ECONOMIC ANALYSIS OF AGRICULTURAL PROJECT.S Second Edition,Complete(y Revised and Expanded JPRICE GITTINGER II 1417 .G58 1982 c.3 .-- i. K9Jf ~iH J. PRICE 'IeM.: ANALYSIS OF - AGRICULTURAL PROJECTs. JOINT BANK-FUND LIBRARY L1 Economc analysis of agricultural projects JLCO 29705 HD14EDI . G5 198 c.3 É 1. . Economic Analysis of Agricultural Proj ects EDI SERIES IN ECONOMIC DEVELOPMENT ��уд.;� .6� .�й�` f"�д, 1�д�а- �' fI ю� � {� } � fr��iи Г _ ,��,.�,. ! _� ь � �s� yI(�"�t)t�'��;�уΡ�� .�г" ' ;��'� у . i.`�*�у�, у i+1''��' � j '$t ,.�у,�wГ�.,". . , h - а Т� �. fts��'J� � �,j �"> �� г� �4 п .л.�q�' у,` ^гг , х ' ' � . `! g } �.д�� }}ггiд' 1�t"t�L� �" . - ,i й , г гт�� . _ д . 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LГJt/� � � ь= HD 141r1 Econor*c Analysis- Of Agn* cultural Proj eas Second Edition, Completely Revised and Expanded j. Price G-fttinger 10 in, t l., 1 br a 1, v WORhýngt,ýn, D. C. 20431 x!, clip PUBLISHED FOR THE ECONOMIC DEVELOPMENT INSTITUTE OF THE WORLD BANK The Johns Hopkins University Press BALTIMORE AND LONDON SECOND EDITION, COMPLETELY REVISED AND EXPANDED, COPYRIGHT ( 1982 BY THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT / THE WORLD BANK 1818 H STREET, N.W., WASHINGTON, D.C. 20433, U.S.A. ALL RIGHTS RESERVED MANUFACTURED IN THE UNITED STATES OF AMERICA The Johns Hopkins University Press Baltimore, Maryland 21218, U.S.A. The views and interpretations in this book are the author's and should not be attributed to the World Bank, to its affiliated organizations, or to any individual acting in their behalf. EDITOR James E. McEuen PRODUCTION Christine Houle FIGURES Raphael Blow INDEX Ralph Ward and James Silvan BOOK DESIGN Brian J. Svikhart COVER DESIGN Joyce C. Eisen Photo credits: World Bank photographs (facing pages) by Hilda Bijur, 437; William Gra- ham, 431; Per Gunvall, 188; Yosef Hadar, 242; Edwin Huffman, papercover, 298; Jaime Martin-Escobal, 42,411; Peter C. Muncie, 64; James Pickerell, 286; Tomas Sennett, frontis- piece, 362, 445, 457; and Ray Witlin, 2, 84, 214. Frontispiece: Milking tethered sheep in Syria. * Karya ini tersedia pula dalam Bahasa Indonesia dengan judul Analhsa Ekonomi Proyek- Proyek Pertanian diterbitkan oleh Penerbit Universitas Indonesia (Jln. Salemba Raya 4, Jakarta). * Une version en franqais de cet ouvrage a 6t& publi6e sous le titre Analyse 6conomique des projets agricoles, Editions Economica (49, rue H6ricart, 75015 Paris, France; distributeur au Canada: Le Diffuseur, C.P. 85, Boucherville, Qu6becJ4B 5E6). * Esta obra tambi6n ha sido publicada en espaiol bajo el titulo Andlisis econ6mico de proyectos agricolas, por la Editorial Tecnos (distribuci6n en Espafia: Grupo Editorial, S.A., Don Ram6n de la Cruz 67, Madrid 1; distribuci6n en otros paises: GSR Internacional, Villafranca 22, Madrid 28, Espafia). Library of Congress Cataloging in Publication Data: Gittinger, J. Price (James Price), 1928- Economic analysis of agricultural projects. (EDI series in economic development) Bibliography: p. 445 Includes index. 1. Underdeveloped areas-Agriculture-Cost effectiveness. 2. Agriculture-Economic aspects. I. Title. II. Series. HD1417.G58 1982 338.1'3 82-15262 ISBN 0-8018-2912-7 AACR2 ISBN 0-8018-2913-5 (pbk.) Foreword To INCREASE THE GROWTH AND EFFICIENCY of the agricultural and rural sectors of the developing countries is of prime concern to the interna- tional community. More rapid progress is crucial not only to improve the quality of life of the 60 percent of the world's population earning its living from rural labor, but also to ensure adequate food supplies for all nations in the face of rapid worldwide population growth and rising incomes that lead people to want more and better-quality food. Unless domestic food production in developing countries steadily increases, these require- ments will place unbearable strains on the world's food production and distribution system-threatening widespread malnutrition in the poorest countries and adding to inflationary pressures in the industrial nations. In the next few years, agriculture and rural development will be a priority in the lending programs of The World Bank and International Development Association (IDA). The World Bank will maintain its sup- port of member governments with technical expertise and a continuing flow of resources. It will help governments to expand irrigation systems, provide more effective extension services, increase food storage capacity, disseminate agronomic technology, and improve the marketing and dis- tribution of agricultural goods. This effort will require large quantities of scarce resources-both peo- ple and money-from our member nations and from the Bank itself. We must use these resources efficiently. V Vi FOREWORD Since its founding the Bank has encouraged, indeed insisted upon, the responsible preparation of the development projects for which it lends. This book is one more implement by which the agricultural work of the Bank is carried out. The Bank shares its experience and skill with member governments and their technical and administrative staffs so that wise and careful investment decisions will yield higher national incomes and a better quality of life for the people of the developing world. In no sector is this sharing of information more important than in agriculture and rural development, where sound investment has such effects on the lives of millions. The Economic Development Institute (ED) has played an important role in disseminating the Bank's experience. Since its founding in 1954, more than 10,000 senior officials from member governments have attended EDI courses both at headquarters in Washington, D.C., and overseas. EDI has helped dozens of institutions throughout the world to provide courses in economic management and project analysis in their own curricula. Economic Analysis of Agricultural Projects derives from the Bank's concern to hasten agricultural and rural development and from the course activities of EDI. The book presents a sound, careful methodology for project analysis based on the efforts of agricultural specialists in the Bank and throughout the world. Care has been taken to make the techni- cal topics discussed understandable to those without advanced training in economics. The book was written to be used either in individual study or in the classroom. We are pleased that the first edition has enjoyed such wide acceptance. Since it was published in 1972, it has become a standard text for those planning agricultural projects and teaching project analysis. In offering this revised edition, with expanded coverage and the addition of more recent experience, we hope to make its contribution even more effective. A. W. CLAUSEN President The World Bank Washington, D.C. June 1982 Contents Foreword by A. W. Clausen v Preface xiii Using This Book xvii PART ONE The Project Concept 1. Projects, The Cutting Edge of Development 3 What Is a Project? 4 Plans and Projects 6 Advantages of the Project Format 7 Limitations of the Project Format 9 Aspects of Project Preparation and Analysis 12 Technical aspects 12 Institutional-organizational-managerial aspects 13 Social aspects 15 Commercial aspects 16 Financial aspects 16 Economic aspects 18 The Project Cycle 21 Identification 21 Preparation and analysis 22 Appraisal 24 Implementation 24 Evaluation 25 Accuracy of Agricultural Project Analyses 26 Economic effects 27 Vii viii CONTENTS Effect on incomes of rural poor 28 Implementation experience 28 Why Agricultural Project Analyses Prove Wrong 29 Problems of project design and implementation 29 Problems of poor project analysis 35 Steps in Project Analysis 37 2. Identifying Project Costs and Benefits 43 Objectives, Costs, and Benefits 43 "With" and "Without" Comparisons 47 Direct Transfer Payments 50 Costs of Agricultural Projects 52 Physical goods 52 Labor 53 Land 53 Contingency allowances 53 Taxes 54 Debt service 54 Sunk costs 55 Tangible Benefits of Agricultural Projects 56 Increased production 56 Quality improvement 57 Change in time of sale 57 Change in location of sale 57 Changes in product form (grading and processing) 58 Cost reduction through mechanization 58 Reduced transport costs 58 Losses avoided 58 Other kinds of tangible benefits 59 Secondary Costs and Benefits 59 Intangible Costs and Benefits 61 PART TWO Financial Aspects of Project Analysis 3. Pricing Project Costs and Benefits 65 Prices Reflect Value 65 Finding Market Prices 69 Point of first sale and farm-gate price 70 Pricing intermediate goods 71 Other problems in finding market prices 72 Project boundary price 74 Predicting Future Prices 74 Changes in relative prices 75 Inflation 76 Prices for Internationally Traded Commodities 77 Financial Export and Import Parity Prices 78 4. Farm Investment Analysis 85 Objectives of Financial Analysis 86 Assessment of financial impact 86 Judgment of efficient resource use 86 Assessment of incentives 86 Provision of a sound financing plan 87 Coordination of financial contributions 87 Assessment of financial management competence 87 CONTENTS ix Preparing the Farm Investment Analysis 89 Elements of Farm Investment Analysis 95 Accounting convention for farm investment analysis 95 Farm resource use 99 Farm production 111 Farm inputs 119 Farm budget 127 Net Benefit Increase 140 Unit Activity Budgets 141 Computing Debt Service 147 Simple interest 147 Repayment of equal amounts of principal 150 Equal installments 153 Equal installments with interest capitalized 157 Declining real burden of debt service 158 Appendix. Herd Projections 163 Terminology and definitions 164 Computational conventions 164 Technical coefficients 165 Animal units 174 Determining the stable herd 175 Tracing the herd growth 179 Machine computation 183 Feed budget 183 5. Financial Analysis of Processing Industries 189 Balance Sheet 192 Income Statement 195 Sources-and-Uses-of-Funds Statement 198 Financial Ratios 202 Efficiency ratios 203 Income ratios 206 Creditworthiness ratios 207 Financial Rate of Return 209 6. Analyzing Project Effects on Government Receipts and Expenditures 215 Government Cash Flow 217 Foreign Exchange Flow 220 Cost Recovery 222 Objectives of cost recovery 223 Setting the level of water charges and benefit taxes 225 Measuring cost and rent recovery 226 Joint Cost Allocation 233 General principles of cost allocation 233 Separable costs-remaining benefits method 234 PART THREE Economic Aspects of Project Analysis 7. Determining Economic Values 243 Determining the Premium on Foreign Exchange 247 Adjusting Financial Prices to Economic Values 250 Step 1. Adjustment for direct transfer payments 251 Step 2. Adjustment for price distortions in traded items 251 Step 3. Adjustment for price distortions in nontraded items 253 X CONTENTS Indirectly traded items 265 Economic export and import parity values 269 Trade Policy Signals from Project Analysis 271 Valuing Intangible Costs and Benefits 279 Decision Tree for Determining Economic Values 284 8. Aggregating Project Accounts 287 Aggregating Farm Budgets 287 Other Aggregation Issues 289 Appendix. A Diagrammatic Project Model 291 Measures of national income 292 Value added 293 Project model 293 PART FOUR Measures of Project Worth 9. Comparing Project Costs and Benefits 299 Undiscounted Measures of Project Worth 300 Ranking by inspection 300 Payback period 302 Proceeds per unit of outlay 302 Average annual proceeds per unit of outlay 303 Average income on book value of the investment 303 The Time Value of Money 304 Interest 305 Compounding 305 Discounting (present worth) 308 Present worth of a stream of future income 309 Discounted Measures of Project Worth 313 Choosing the discount rate 313 Discounting convention for project analysis 315 Derivation of Incremental Net Benefit (Incremental Cash Flow) 315 Net Present Worth 319 Internal Rate of Return 329 Computing the internal rate of return 332 Reinvestment of returns 339 More than one possible internal rate of return 339 Point in time for internal rate of return calculations 341 Benefit-Cost Ratio 343 Net Benefit-Investment Ratio 346 Selecting among Project Alternatives 350 What Happened to Depreciation? 351 Length of the Project Period 355 How Far to Carry Out Computations of Discounted Measures 356 Comparisons among Discounted Measures 358 Appendix. Mathematical Formulations of Discounted Measures of Project Worth 361 10. Applying Discounted Measures of Project Worth 363 Sensitivity Analysis (Treatment of Uncertainty) 363 Price 364 Delay in implementation 364 Cost overrun 364 Yield 365 Technique of sensitivity analysis 365 Switching Value 371 CONTENTS Xi Choosing among Mutually Exclusive Alternatives 373 Entirely different projects 377 Different scales of a project 379 Different timing of a project 381 Choice between technologies (crossover discount rate) 383 Additional purposes in multipurpose projects 388 Applying Contingency Allowances 393 Replacement costs 395 Residual value 397 Domestic resource cost 398 Calculating Measures of Project Worth Using Current Prices 400 Calculator Applications in Project Analysis 401 Appendixes A. Guidelines for Project Preparation Reports 411 1. Summary and Conclusions 412 2. Iritroduction 412 3. Background 413 3.1 Current economic situation 413 3.2 The agricultural sector 413 3.3 Development and social objectives 413 3.4 Income distribution and poverty 413 3.5 Institutions 414 4. Project Rationale 414 5. The Project Area 414 5.1 Physical features 414 5.2 Economic base 415 5.3 Social aspects 416 5.4 Infrastructure 417 5.5 Institutions 417 6. The Project 417 6.1 Project description 418 6.2 Detailed features 418 6.3 Project phasing and disbursement period 419 6.4 Cost estimates 420 6.5 Financing 421 6.6 Procurement 422 6.7 Environmental impact 422 7. Organization and Management 422 7.1 Credit administration 423 7.2 Marketing structure 423 7.3 Supply of inputs 424 7.4 Land reform 424 7.5 Research 424 7.6 Extension 424 7.7 Cooperatives 424 7.8 Farmer organization and participation 424 8. Production, Markets, and Financial Results 425 8.1 Production 425 8.2 Availability of markets 425 8.3 Farm income 426 8.4 Processing industries and marketing agencies 426 8.5 Government agencies of project authorities 426 8.6 Cost recovery 426 Xii CONTENTS 9. Benefits and Justification 427 9.1 Social benefit 427 9.2 Economic benefit 428 10. Outstanding Issues 428 11. Annexes 428 B. Three-decimal Discounting Tables 431 Compounding Factor for 1 432 Compounding Factor for 1 per Annum 432 Sinking Fund Factor 432 Discount Factor 433 Present Worth of an Annuity Factor 433 Capital Recovery Factor 433 C. Sources of Institutional Assistance for Project Preparation 437 Bilateral Assistance 437 Multilateral Assistance 437 European Community 438 United Nations Development Programme 438 Food and Agriculture Organization-Development Bank Cooperative Programs 439 World Bank 440 Consultants 441 Bibliography 445 Glossary-Index 457 Preface THIS BOOK was written to provide those responsible for agricultural investments in developing countries with sound analytical tools they can apply to estimate the income-generating potential of proposed projects. Scope and Methodology The book has not been written only for a narrow grouping of agricul- tural economists. Rather, it is intended for all who must share in shaping agricultural projects if these undertakings are to be high-yielding invest- ments: agronomists, livestock specialists, irrigation engineers, and many others. All these people are meant when the term "analyst" is used. To the existing resources of these diverse professionals, the book adds a tool for multidisciplinary use so that many with many skills can work together in applying their knowledge to analyze proposed projects. The formal economic theory underlying the analytical system outlined here is not complicated; it certainly is not so technical as to cause problems for noneconomists. For those not already familiar with it, I have discussed the necessary economic theory in the course of the pre- sentation and have defined technical terms both in the text and in the glossary-index at the end of the book. The mathematical techniques used are also simple; they are limited to addition, subtraction, division, multi- xiii xiv PREFACE plication, and the simplest algebra. The computations needed for project analysis, however, are too tedious to be done by hand. A simple elec- tronic calculator is a virtual necessity (see chapter 10 under "Calculator Applications in Project Analysis"), but there is no need for advanced calculators or computers. The analytical system outlined in this book is a consistent statement of the general methodology currently employed by the World Bank for all but a few of its project analyses (Gittinger, Garg, and Thieme 1982). (The details of World Bank analyses vary somewhat according to the sector and the views of individual analysts.) With minor variations, the system is also used by most international agencies concerned with capital trans- fer, including the African Development Bank, the Asian Development Bank, and the Inter-American Development Bank. The economic analy- sis in this system is based on "efficiency prices"-prices that show effects on national income broadly defined. The system enables us to judge which among project alternatives is most likely to contribute the largest amount to national income. The system underlies millions of dollars of investment decisions made every year. Thick volumes of economic analy- sis backing up proposed investments usually involve nothing more com- plicated than what is discussed in the following pages-although large investments may require much elaboration and may involve intermedi- ate steps to accommodate all the "ins" and "outs" of a complex agri- cultural project. In recent years several analytical systems have been proposed that extend the methodology outlined here to take into account not only the contribution a project makes to national income but also the effect of a project on income distribution and saving. Most notable are those of Little and Mirrlees (1974), the United Nations Industrial Development Organization (UNIDO) (1972a), and Squire and van der Tak (1975). These analytical systems, which remain the subject of much professional dis- cussion, are far more complex than the one I have presented. The system outlined here, however, is compatible with these more complex systems; in fact, Squire and van der Tak recommend the same methodology for project identification and valuation. The difference is that, once Squire and van der Tak have determined economic values on the basis of efficiency prices, they then proceed to weight those values to account for income distribution and saving. In the analytical system given here, we will stop with the efficiency price analysis. We will then suggest making a subjective decision to choose among the high-yielding alternatives the one that has the most favorable effects on income distribution, saving, and other national objectives. The system outlined here is not im- mediately adaptable to the Little and Mirrlees or the UNIDO systems, but there are no major conceptual differences up to the point we carry the analysis. Both Little and Mirrlees and UNIDO recommend further refine- ments to allow for the effects on income distribution and saving that are not incorporated in the formal analytical scheme recommended here. PREFACE XV The Revised Edition Compared with the first edition, published in 1972, this second, revised edition has an expanded discussion of the project approach that incorpo- rates more recent experience and provides more detailed and rigorous treatment of identifying, pricing, and valuing costs and benefits. The basic analytical system, however, is unchanged. Much additional mate- rial has been added on farm budgets and other aspects of financial analysis, and a bit more on the methodology of comparing costs and benefits. In the Economic Development Institute (EDI), the first edition has been extensively used for teaching project analysis. The sequence of topics taken up in EDI courses on agricultural and rural development, rural credit, livestock, and irrigation projects generally follows the order found here. Thus, the overall concept of a project is presented first, followed by farm budgets and financial analysis, and then by economic analysis. (For a more detailed description of the process of project analy- sis, and of the organization of the chapters in this book, see the last section of chapter 1, "Steps in Project Analysis.") In practice, however, the methodology of comparing costs and benefits discussed in chapters 9 and 10 is usually taught in parallel with the topics on financial and economic analysis. This both permits a change of pace in the teaching and gives course participants more time to practice using methodologi- cal tools before proceeding to case studies in which they are asked to apply their knowledge of financial and economic analysis and their methodological skills. EDI has prepared a number of case studies and other training materials to teach agricultural and rural development project analysis, and these are available to others teaching these sub- jects. (See the last page of this book for information about how to obtain these materials.) Acknowledgments I could never have written a book such as this without extensive help from many, many people. The book grows out of lectures and training materials prepared for EDI courses, and its style reflects its origin. I have benefited enormously from, and this revised edition has been informed by, participants in these courses both at EDi headquarters and in develop- ing countries. Readers will note I have made liberal use of training materials prepared by my colleagues. It is impossible to acknowledge all the individuals who have helped me, but special appreciation should be expressed to Hans A. Adler, George B. Baldwin, Maxwell L. Brown, Colin F. M. Bruce, Orlando T. xvi PREFACE Espadas, F. Leslie C. H. Helmers, P. D. Henderson, William I. Jones, Klaus Meyn, Frank H. Lamson-Scribner, David H. Penny, Walter Schaef- er-Kehnert, Arnold von Ruemker, Jack L. Upper, and William A. Ward, all presently or formerly with the EDI; to numerous present and former staff working with agricultural projects in the World Bank, especially Graham Donaldson, Lionel J. C. Evans, John D. Von Pischke, Gordon Temple, Willi A. Wapenhans, and A. Robert Whyte; and to Frederick J. Hitzhusen, Ohio State University, and John D. MacArthur, University of Bradford. J. PRICE GITTINGER Using This Book THE ORGANIZATION, conventions and notation, and special features of this book are briefly explained here at the outset for the reader's convenience. Organization of Chapters Chapters are presented in an order that in general follows the process of preparing an agricultural project analysis. The sequence of this pro- cess is described in the last section of chapter 1, "Steps in Project Analy- sis." Because the analytical process is iterative, chapters frequently contain cross-references to appropriate sections and subsections in other chapters. Computations Project analyses rest on many assumptions that by their very nature are only approximate. The final results of computations, therefore, should be rounded with this limitation in mind and presented appro- priately with only significant digits included-say, in millions or thousands of currency units, thousands or hundreds of tons or hectares, or the like. To make methodological points more apparent, however, many illustrative computations in this book have been carried out much xvii XVIII USING THIS BOOK further than called for by such a rule. Hence, they should not be taken as a model for presentation. (See the section in chapter 9 entitled "How Far to Carry Out Computations of Discounted Measures" for a discussion of this topic.) Decimals and commas in numbers Throughout this book, a decimal is indicated by a point set level with the bottom of the line of type (.). In numbers of 1,000 or greater (except those designating the year), a comma (,) distinguishes groupings of thousands. Thus, 1 million would be written 1,000,000.0. Whenever a decimal fraction appears that is less than 1, a zero appears before the decimal point to avoid misreading the fraction; thus, one-fourth appears in decimal form as 0.25. Rounding convention For all computations in this book, the following rules have been used for rounding: 1. When a value of less than 5 is to be dropped, the digit to the left is unchanged. 2. When a value of more than 5 is to be dropped, the digit to the left is increased by 1. 3. When a value of exactly 5 is to be dropped, the digit to the left, if even, is left unchanged; if odd, it is raised by 1. Under this rule, all numbers that have been rounded by dropping an exact value of 5 are reported as even numbers. Thus, in the first illustrative tabulation in the "Compounding" subsec- tion of chapter 9, the following rounding will be found: 1,050 x 1.05 = 1,102.50 rounded to 1,102 (Rule 3) 1,102 x 1.05 = 1,157.10 rounded to 1,157 (Rule 1) 1,157 x 1.05 = 1,214.85 rounded to 1,215 (Rule 2). Calculations Throughout the text, illustrative calculations made in project analysis are given (within parentheses or brackets) after the explanation of how they are derived. Most of these calculations are done by simple arithme- tic. (For the sake of completeness, there are many calculations presented in this manner that are very simple; I hope the reader will be patient with such obvious examples.) More elaborate formulas are displayed on the page. Units of Measurement and Currency Metric units are used for all measurements unless otherwise speci- fied-thus, "tons" refers to metric tons, not "long" or "short" tons. USING THIS BOOK XiX Special units-for example, "animal units" or "work days"-are defined in the text and in the glossary-index (see "Supporting Materials," below). To emphasize the worldwide scope of agricultural development efforts, examples of project accounts give money amounts in the cur- rency of the country in which the project is located. The standard sym-- bols for these currencies are identified in the text and tables; when appropriate, generic "currency units" are also used. Notation An explanation of the conventions used for notation in this book may help in reading the tables, mathematical formulations, and the six- decimal discount factors. Tables In the tables in this book a zero indicates "none" or "no amount," and a dash (-) indicates "not applicable." In chapters 4, 5, and 6, and in tables 9-7 and 9-8 where financial accounts are discussed, the accounting con- vention of indicating negative numbers by parentheses has been adopted. In all other tables, negative numbers are indicated by a minus sign (-). The tables in this book are of several general kinds: tables that lay out methods of calculation (for example, tables 3-3 and 7-2); "pattern account" tables that lay out a recommended format for project accounts for either financial analysis (the tables in chapter 4) or economic analysis (the tables in chapter 7); and the usual sort of table that simply presents project data. In some of the pattern account tables additional information for under- standing (for example, the financial or economic rate of return) is given after the main rows of entries. The reader is reminded that, to arrive at the total values in the tables of chapters 9 and 10 that include entries for multiyear spans, annual amounts must be included for the number of years involved. In tables that illustrate financial accounts, the reader should note that in some cases intervening years have been omitted (see, for example, table 5-1). To aid computation, portions of Compounding and Discounting Tables for Project Evaluation (Gittinger 1973) have been reproduced in the seven compounding and discounting tables that appear in this book. Mathematics As noted above, standard arithmetical notation has been used through- out the book. When division is indicated in a line of figures, a division sign (+) is used rather than a slash (/). In the section in chapter 10 entitled "Calculator Applications in Project Analysis" the operations that are indicated on the keys of the simple electronic calculator used are shown in the text in boldface type. XX USING THIS BOOK Six-decimal discount factors When six-decimal discount factors are used in the text or in tables, a notation of inserting a space between the third and fourth decimal places has been followed to make the factors easier to read. Technical Terms Specialized financial, accounting, economic, and project terms (and the few acronyms and abbreviations used in the book) have been com- piled and defined in the glossary-index (see "Supporting Materials," below). The most important of these, of course, are also defined in the text where they apply. As a guide to understanding the format of project accounts, the prin- cipal headings of the pattern account tables-categories that are likely to appear in most agricultural project analyses-have been listed in italic type in the text of chapters 4, 5, 6, and 8. Supporting Materials The reader may find supporting materials that are included in this book, or available from the sources indicated, helpful for further study of project analysis. Appendixes Chapter appendixes supplement the discussion of topics in chapters 4, 8, and 9. Appendixes to the book provide general guidelines for preparing an agricultural project analysis report (appendix A); give summary dis- counting tables for common discount rates and the formulas for comput- ing discount factors directly using an electronic calculator (appendix B); and discuss the bilateral and multilateral sources of specialized assist- ance for the preparation of complex agricultural projects (appendix C). The assistance discussed in appendix C is negotiated and undertaken at the institutional level by the agencies and governments involved. Bibliographic sources Primary sources have been identified in the text by the author's sur- name and the publication date of the material cited. These sources, and additional references, are listed and annotated in the bibliography. Sources of some individual tables and figures are not listed in the bibliography but are cited in full in the appropriate table or figure legend. Some of these source materials have restricted circulation and are unavailable to the general public. USING THIS BOOK XXI I could not have written this book without access to the experience of the Economic Development Institute (EM) and its parent institution, the World Bank. The record of this experience is predominantly in the public domain. Information about how to obtain publications of the EDI and of the World Bank will be found on the last page of this book. Glossary-Index As an aid to the reader, the index has been enhanced by incorporating glossary entries that define the principal technical terms used in this book. Because interpretation of some of these terms varies among the specialists involved in preparing agricultural project analyses (these professionals are an inquisitive lot-they have to be-and the field is a dynamic and changing one), the definitions given cannot be "defini- tive"-they reflect the use of these terms in this book. Project examples Data from actual agricultural project investments assisted by the World Bank or other international development agencies or financed by governments have been used to illustrate the analytical methodology presented here. The adaptation and interpretation of these data are my own. The use of project information in this book is purely illustrative; it does not represent a judgment by the funding agency or borrowing government about any particular project. PART ONE The Project Concept л ...�; ��. , �, ' � ''� �, а 1� ..�, " '��дΡ._.�.��,в�� , •e.yg.. �% »>i.�'. -ич �.. �; �# _3�."У' � �.- .. � `.с� �.у � "' p.wY �-а/��;�� ,1 \р .3 � у * , •�� ' • . --.. , , . , -ж .'-wfь� {�1 ♦п - �' ,�в(�. ; ��'� _ . �`Я�гвs.°"^3 _ .. .�t•� :. lj�I;�f7,p _ ' `,. ' �� F� � ,.�`,• �, _.ы ..{/. �` чн _ .ыw кь (- уΡ ы � � ��' +}•, 1э ; '`�ы _ '� ,�� С��'l - i�� ° � - а - i 2 . � � � - � ��.- -> �� • ��,. _. а � � � w �. ' � � Г"•в-�` ^� лwг`^�,�р � 'S' - � � а , ' ; _ ti ''F � . . � _ в . ,' � ` 4 _ - � - '-. . ,.:. 41 � r.^ s:�'_ � `��'" •'`�t-_: а � ` ' ,�г 'Саыл • -' �' ' ..- . � ' � `��'�' _ � .. . �г� . . � 1 Projects, The Cutting Edge of Development PROJECTS ARE THE CUTTING EDGE OF DEVELOPMENT. Perhaps the most dif- ficult single problem confronting agricultural administrators in develop- ing countries is implementing development programs. Much of this can be traced to poor project preparation. Project preparation is clearly not the only aspect of agricultural de- velopment or planning. Identifying national agricultural development objectives, selecting priority areas for investment, designing effective price policies, and mobilizing resources are all critical. But for'most agricultural development activities, careful project preparation in ad- vance of expenditure is, if not absolutely essential, at least the best available means to ensure efficient, economic use of capital funds and to increase the chances of implementation on schedule. Unless projects are carefully prepared in substantial detail, inefficient or even wasteful ex- penditure is almost sure to result-a tragic loss in nations shoit of capital. Yet in many countries the capacity to prepare and analyze projects lags. Administrators, even those in important planning positions, con- tinually underestimate the time and effort needed to prepare suitable projects. So much attention is paid to policy formulation and planning of a much broader scope that administrators often overlook the specific Facing page: Plowing a field in Rajasthan, India. 3 4 THE PROJECT CONCEPT projects on which to spend available money and on which much develop- ment depends. Ill-conceived, hastily planned projects, virtually impro- vised on the spot, are too often the result. What Is a Project? In this book we will discuss how to compare the stream of investment and production costs of an agricultural undertaking with the flow of benefits it will produce. The whole complex of activities in the undertak- ing that uses resources to gain benefits constitutes the agricultural proj- ect. If this definition seems broad, it is intentionally so. As we shall see, the project format can accommodate diverse agricultural endeavors. An enormous variety of agricultural activities may usefully be cast in proj- ect form. The World Bank itself lends for agricultural projects as differ- ent as irrigation, livestock, rural credit, land settlement, tree crops, agricultural machinery, and agricultural education, as well as for mul- tisectoral rural development projects with a major agricultural compo- nent. In agricultural project planning, form should follow analytical content. We generally think of an agricultural project as an investment activity in which financial resources are expended to create capital assets that produce benefits over an extended period of time. In some projects, however, costs are incurred for production expenses or maintenance from which benefits can normally be expected quickly, usually within about a year. The techniques discussed in this book are equally applica- ble to estimating the returns from increased current expenditure in both kinds of projects. Indeed, the dividing line between an "investment" and a "production" expenditure in an agricultural project is not all that clear. Fertilizers, pesticides, and the like are generally thought of as production expenses used up within a single crop season or, in any event, within a year. A dam, a tractor, a building, or a breeding herd is generally thought of as an investment from which a return will be realized over several years. But the same kind of activity may be considered a production expense in one project and an investment in another. Transplanting rice is a production expense. Planting rubber trees is an investment. But from the standpoint of agronomics and economics they are not different kinds of activities at all. In both cases young plants grown in a nursery are set out in the fields, and from them a benefit is expected when they mature. The only differ- ence is the time span during which the plants grow. Often projects form a clear and distinct portion of a larger, less pre- cisely identified program. The whole program might possibly be ana- lyzed as a single project, but by and large it is better to keep projects rather small, close to the minimum size that is economically, technically, and administratively feasible. Similarly, it is generally better in plan- ning projects to analyze successive increments or distinct phases of activity; in this way the return to each relatively small increment can be PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 5 judged separately. If a project approaches program size, there is a danger that high returns from one part of it will mask low returns from another. A 100,000-hectare land settlement program may well be better analyzed as five 20,000-hectare projects if the soils and slopes in some parts are markedly different from those in others. Analyzing the whole project may hide the fact that it is economically unwise to develop some parts of the 100,000-hectare area instead of moving on to an entirely different region. When arranging for external financing or planning the adminis- trative structure, it is sometimes convenient for planners to group sev- eral closely related projects into a single, larger "package." In these instances it may still be preferable to retain the separate analyses of individual components, in a composite of the whole, rather than to aggregate them into a single, overall analysis. Again, all we can say in general about a project is that it is an activity for which money will be spent in expectation of returns and which logically seems to lend itself to planning, financing, and implementing as a unit. It is the smallest operational element prepared and implemented as a separate entity in a national plan or program of agricultural develop- ment. It is a specific activity, with a specific starting point and a specific ending point, intended to accomplish specific objectives. Usually it is a unique activity noticeably different from preceding, similar invest- ments, and it is likely to be different from succeeding ones, not a routine segment of an ongoing program. It will have a well-defined sequence of investment and production activities, and a specific group of benefits, that we can identify, quantify, and, usually in agricultural projects, determine a money value for. If development can be pictured as a progression with many dimen- sions-temporal, spatial, sociocultural, financial, economic-projects can be seen as the temporal and spatial units, each with a financial and economic value and a social impact, that make up the continuum. A project is an undertaking an observer can draw a boundary around-at least a conceptual boundary-and say "this is the project." As well as its time sequence of investments, production, and benefits, the project nor- mally will have a specific geographic location or a rather clearly under- stood geographic area of concentration. Probably there will also be a specific clientele in the region whom the project is intended to reach and whose traditional social pattern the project will affect. Given the usefulness of the project format in the development process, the project has increasingly been used as a "time slice" of a long-term program for a region, a commodity, or a function such as agricultural extension. Although such.projects normally have a definite beginning and end, the importance of these starting and finishing points is reduced. Such a use of the project format also makes quantification of benefits more difficult because some benefits may not be realized until subse- quent phases of the program that are not included in the project. Often a project will have a partially or wholly independent administrative struc- ture and set of accounts and will be funded through a specifically defined financial package. I hope that, after following the methodology presented 6 THE PROJECT CONCEPT here, readers will also subject their projects to an analysis of financial results and economic justification. People are sometimes concerned that they do not have an academic definition of what a project is. There is no need to be; in practice, the definition works itself out. There are much more important aspects of project analysis to grapple with than an academic formulation of a project definition. Plans and Projects Virtually every developing country has a systematically elaborated national plan to hasten economic growth and further a range of social objectives. Projects provide an important means by which investment and other development expenditures foreseen in plans can be clarified and realized. Sound development plans require good projects, just as good projects require sound planning. The two are interdependent. Sound planning rests on the availability of a wide range of information about existing and potential investments and their likely effects on growth and other national objectives. It is project analysis that provides this information, and those projects selected for implementation then become the vehicle for using resources to create new income. Realistic planning involves knowing the amount that can be spent on development activities each year and the resources that will be required for particular kinds of investment. Project selection must always be based in part on numerical indicators of the value of costs and returns. These can often be measured through valuation at the market prices-the prices at which goods or services are actually traded. Unfortunately, however, market prices may be mislead- ing indicators of the use and return of real resources, so governments need to look at other aspects of potential investments to judge the real effects the investments will have. For this, good project analysis is a tremendous asset, since the investment proposal can be valued to reflect the true scarcity of resources when market prices do not. (Note that by market prices we refer to the actual prices at which goods and services are traded in a generalized system of exchange, not to the particular place at which the exchange takes place. To talk of a village "market" or a wholesale "market" is to use the word in a slightly different sense. This may seem an obvious distinction, but in project analysis it does make a difference whether the "market price" is collected in the appropriate "market," and we will return to this issue later.) Well-analyzed projects often become the vehicle for obtaining outside assistance when both the country and the external financing agency agree on a specific project activity and know the amount of resources involved, the timing of loan disbursements, and the benefits likely to be realized. But project analysis should not be confined to only those invest- ments for which external financing will be sought. The more investments there are that can be analyzed as projects, the more likely it is that the total use of resources for development will be efficient and effective. To PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 7 concentrate a high proportion of available analytical skills on preparing projects for external assistance, and to leave investment of local re- sources basically unplanned, is a wasteful allocation of talent. If careful- ly designed and high-yielding projects are offset by essentially unplan- ned investments, then the net contribution to national objectives is substantially undermined. Sound planning requires good projects, but effective project prepara- tion and analysis must be set in the framework of a broader development plan. Projects are a part of an overall development strategy and a broader planning process; as such, they must fit appropriately. Governments must allocate their available financial and administrative resources among many sectors and many competing programs. Project analysis can help improve this allocation, but it alone cannot be relied upon to achieve the optimal balance of objectives. Within the broad strategy, analysts must identify potential projects that address the policy or pro- duction targets and priorities. Further, to make a realistic estimate about the course of a project, some idea must be gained of what other develop- ment activities will be taking place and what policies are likely to be pursued. Will employment growth make labor relatively more produc- tive and thus more expensive to use in the project? Will input supplies be available at the time the project needs them? Will quotas be relaxed? Will food grain prices be allowed to rise? Integration of plans and proj- ects becomes all the more important as the size of the project grows larger relative to the total economy. If the project alone is likely to have a significant effect on the availability of resources and on prices in the economy as a whole, then it must be very carefully planned in coordina- tion with other investments and within an appropriate policy framework included in the national plan. For the project itself, some elements used in agricultural project analy- sis should not be worked out in isolation by the individual analyst. All the projects being prepared and analyzed should use a consistent set of assumptions about such things as the relative scarcity of investment funds, foreign exchange, and labor. All project analyses should use the same assumptions about the social policies and objectives to be reflected in such decisions as the location of the project, the size of the landholding to be established, the amount of social services to be included, and the like. Advantages of the Project Format Projects carefully prepared, within the framework of broader develop- ment plans, both advance and assess the larger development effort. The project format itself is an analytical tool. The advantage of casting proposed investment decisions in the project format lies in establishing the framework for analyzing information from a wide range of sources. Because no plan can be better than the data and assumptions about the future on which it is based, the reality of the analysis to a large degree 8 THE PROJECT CONCEPT depends on information from various sources and the considered judg- ments of various specialists in different areas. The project format facili- tates gathering the information and laying it out so that many people can participate in providing information, defining the assumptions on which it is based, and evaluating how accurate it is. The project format gives us an idea of costs year by year so that those responsible for providing the necessary resources can do their own plan- ning. Project analysis tells us something about the effects of a proposed investment on the participants in the project, whether they are farmers, small firms, government enterprises, or the society as a whole. Looking at the effects on individual participants, we can assess the possible incen- tives a proposed project has and judge if farmers and others may success- fully be induced to participate. Casting a proposed investment in project form enables a better judg- ment about the administrative and organizational problems that will be encountered. It enables a strengthening of administrative arrangements if these appear to be weak and tells something of the sensitivity of the return to the investment if managerial problems arise. Careful project planning should make it more likely that the project will be manageable and that the inherent managerial difficulties will be minimal. The proj- ect format gives both managers and planners better criteria for monitor- ing the progress of implementation. The project format encourages conscious and systematic examination of alternatives. The effects of a proposed project on national income and other objectives can conveniently be compared with the effects of proj- ects in other sectors, of other projects in the same sector, or-very impor- tant-of alternative formulations of virtually the same project. One alternative can be the effects of no project at all. Another advantage of the project format is that it helps contain the data problem. In many developing countries, national data are unavail- able or are, to a substantial degree, unreliable. It is true that a project must be seen in a national context, but in many instances the direction that a country's development effort should take is well known, even if precise figures are not available. Most countries know they must increase food production even if they cannot cite reliable figures about total production or recent growth rates. By channeling much of the develop- ment effort into projects, the lack of reliable national data can be miti- gated. Once the project area or clientele has been determined-once a conceptual boundary has been drawn-local information on which to base the analysis can be efficiently gathered, field trials can be under- taken, and a judgment can be made about social and cultural institutions that might influence the choice of project design and its pace of imple- mentation. Investment can then proceed with confidence. Because of the advantages of the project format in development plan- ning, I would recommend that its use be extended to as many kinds of investment analysis as possible, even when this stretches the form. For projects of the production type-with clear-cut investments and easily valued costs and benefits, as is so often the case in agriculture-the PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 9 project format is of course well suited. But many kinds of activities that might otherwise be thought of as programs can also be effectively cast in project form. Rural credit activities and even agricultural education, agricultural extension, and agricultural research can be put in project form to good effect, although the benefits from these kinds of projects may be impossible to value. In these instances, the orientation of the analysis may simply be changed to that of least-cost comparisons, and the other advantages of the project format will continue to be realized. These include systematic contributions to the preparation and review of the project by a wide range of specialists, carefully specified objectives, systematic consideration of alternatives, year-by-year estimates of cost, and the opportunity to examine carefully the organizational and man- agerial implications. Limitations of the Project Format Although the project format has many advantages, the results of proj- ect analysis must be interpreted with caution. Obviously, the quality of project analysis depends on the quality of the data used and of the forecasts of costs and benefits made. Here the GIGO principle-"garbage in, garbage out"-works with a vengeance. Unrealistic assumptions about yields, acceptance by farmers, response to incentives by entrepre- neurs, the trend of future prices and the relative effect of inflation upon them, market shares, or the quality of project management can make garbage out of the project analysis. To begin with, projects will exist in a changing technical environment. For some projects the possibility of technological obsolescence will affect judgments about the attractiveness of the investment. Fortunately, in agriculture this is not often a serious problem, although in other sectors it can be. Because future circumstances will change, we must judge the risk and uncertainty surrounding a project, and here techniques of project analy- sis offer only limited help. It is impossible to quantify completely the risks of a project. We can, however, note that different kinds of projects or different formulations of essentially the same project may involve differ- ent degrees of risk. These differences will affect the choice of project design. We can also test a project for sensitivity to changes in some specific element, see how the benefit produced by the project will be affected, and then judge how likely it is that such changes will occur and whether the changes in benefits will alter our willingness to proceed. We could do such "sensitivity analysis," for example, by assuming that future yields will be less than our best estimate or that future prices will be lower than the level of our most likely projection, and then decide how probable such shortfalls will be and whether we still wish to continue with the project. Sensitivity analyses that simply assume "all costs increased by 10 percent" or "all benefits lowered by 10 percent," which are easy to perform if machine computation is used, are generally of little 10 THE PROJECT CONCEPT usefulness; tests for specific changes that can lead to decisions on project design are far superior. Techniques have been developed for more formal analysis of risk, but they have not been widely applied to agricultural projects. They rest on assigning probabilities to a range of alternative assumptions. These techniques are complex and generally require machine computation. Project analysis is a species of what economists call "partial analysis." Normally we assume that the projects themselves are too small in rela- tion to the whole economy to have a significant effect on prices. In many instances, however, a proposed project is relatively large in relation to a national or regional economy. In this event we must adjust our assump- tions about future price levels to take account of the impact of the project itself. At best, such adjustments are approximate and may severely limit the usefulness of the measures of project worth that will be discussed in chapter 9. Much more elaborate analytical procedures than those dis- cussed here must then be called into play-generally some form of a programming model. Such techniques were used by the World Bank to analyze development of the Indus Basin in India and Pakistan, for in- stance (Lieftinck, Sadove, and Creyke 1968), and have been applied to regional agricultural development programs in Mexico (Norton and Solis 1982) and Brazil (Kutcher and Scandizzo 1981), among other coun- tries. Even in those instances, however, the partiality of the assumptions means that the results must be interpreted with care. The greater the differences among alternative projects, the more dif- ficult it is to use formal analytical techniques to compare them. Financial and economic analyses of the sort discussed in this book are quite good for comparing such close alternatives as two versions of an irrigation project, or even an irrigation project and a land settlement project. They are relatively good for comparing alternative projects having costs and benefits that can be valued reasonably well-for instance, a project for a food processing plant and another for irrigation. But when we wish to compare projects whose benefits can be valued rather well (such as projects to increase agricultural output, or light manufacturing projects) with projects whose benefits cannot be valued (such as education or rural domestic water supply projects), then the formal techniques can hardly be used to determine the best alternative. In such instances, the alloca- tion between different projects must be done more subjectively and as part of an overall development plan. The usefulness of the project format in these instances is not so much in facilitating comparison between two projects as in ensuring that both projects are planned so that they can be carried out efficiently. By and large, project analysis is more useful when it is applied to unique investment activities. Ongoing services such as police and fire protection, extension services, export promotion, and even normal education services are probably better treated as part of a program than as individual projects. The project form works best where there is a rather clear investment-return cycle and a rather clear definition of geographical area or clientele. PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 11 Another limitation of the project format is an underlying conceptual problem about valuation based on the price system. The relative value of items in a price system depends on the relative weights that individuals participating in the system attach to the satisfaction they can obtain with their incomes. They choose among alternatives, and thus the prices ,-of goods and services balance with the values attached to these goods and services by all who participate in the market. Such a system, however, reflects the distribution of income among its participants; in the end, values trace back to existing income distribution. Project analysis takes as a premise that inequities of income distribution can be corrected by suitable policies implemented over a period of time. If such a premise is not accepted, then the whole basis of the valuation system in project analysis (and of the underlying price system upon which it rests) is called into question. Although project analysis must consciously be placed in a broader political and social environment, in general the effects of a project on this environment can be assessed only subjectively. Often economists refer to "externalities" or side effects, such as skill creation and the development of managerial abilities, that are by-products of a project. Projects may also be undertaken to further many objectives-such as regional integra- tion, job creation, or improving rural living conditions-beyond eco- nomic growth alone. The less subject to valuing these objectives are, the less formal are the project analysis techniques that can be used to com- pare them, although the project format can still be effectively used to encourage careful planning and efficiency. Furthermore, projects are not the only development initiatives that governments may undertake. The development process calls for such measures as good price policies, carefully designed tariff policies, and participation in discussions to obtain wider market access, and none of these lends itself easily to being cast in project form. Projects are planned and implemented in a political environment. This is as it must be, since it is the political process that enables societies to balance many, often conflicting, objectives. But questions inevitably arise about the political overtones of project analysis. Is the "national" interest the same as the "social" interest? In project planning and analy- sis how do we adequately incorporate such considerations as national integrity, nation building, or national defense? One objective may be to benefit disadvantaged groups or regions, but projects in which these objectives are important may not always be the most remunerative. Political leaders must respond to all sorts of pressures, and the way they weigh various tradeoffs may not lead to the same conclusions a project analyst would reach. All this is to say that, even though the analytical methods we will discuss can be of great help in identifying which projects will increase national income most rapidly, they will not make the actual decision of project investment. That decision is one on which many, many factors other than quantitative or even purely economic considerations must be brought to bear. A settlement project and a plantation project may have 12 THE PROJECT CONCEPT roughly similar economic benefits, but the settlement alternative may be chosen because it promises better income distribution benefits. Or, the analysis may reveal that the plantation project is more profitable and may give an idea of just how much so. Is the social benefit of the lower- paying project worth forgoing the probable future income from the higher-paying project? In the final analysis, any national investment decision must be a political act that embodies the best judgment of those responsible. The function of project analysis is not to replace this judg- ment. Rather, it is to provide one more tool (a very effective one, we hope) by which judgment can be sharpened and the likelihood of error reduced. Aspects of Project Preparation and Analysis To design and analyze effective projects, those responsible must con- sider many aspects that together determine how remunerative a pro- posed investment will be. All these aspects are related. Each touches on the others, and a judgment about one aspect affects judgments about all the others. All must be considered and reconsidered at every stage in the project planning and implementation cycle. A major responsibility of the project analyst is to keep questioning all the technical specialists who are contributing to a project plan to ensure that all relevant aspects have been explicitly considered and allowed for. Here we will divide project preparation and analysis into six aspects: technical, institutional- organizational-managerial, social, commercial, financial, and economic. These categories derive from those suggested by Ripman (1964), but alternative groupings would be equally valid for purposes of discussion. Technical aspects The technical analysis concerns the project's inputs (supplies) and outputs (production) of real goods and services. It is extremely impor- tant, and the project framework must be defined clearly enough to per- mit the technical analysis to be thorough and precise. The other aspects of project analysis can only proceed in light of the technical analysis, although the technical assumptions of a project plan will most likely need to be revised as the other aspects are examined in detail. Good technical staff are essential for this work; they may be drawn from consulting firms or technical assistance agencies abroad. They will be more effective if they have a good understanding of the various aspects of project analysis, but technical staff, no matter how competent, cannot work effectively if they are not given adequate time or if they do not have the sympathetic cooperation and informed supervision of planning officials. The technical analysis will examine the possible technical relations in a proposed agricultural project: the soils in the region of the project and their potential for agricultural development; the availability of water, both natural (rainfall, and its distribution) and supplied (the possibilities 12 THE PROJECT CONCEPT roughly similar economic benefits, but the settlement alternative may be chosen because it promises better income distribution benefits. Or, the analysis may reveal that the plantation project is more profitable and may give an idea of just how much so. Is the social benefit of the lower- paying project worth forgoing the probable future income from the higher-paying project? In the final analysis, any national investment decision must be a political act that embodies the best judgment of those responsible. The function of project analysis is not to replace this judg- ment. Rather, it is to provide one more tool (a very effective one, we hope) by which judgment can be sharpened and the likelihood of error reduced. Aspects of Project Preparation and Analysis To design and analyze effective projects, those responsible must con- sider many aspects that together determine how remunerative a pro- posed investment will be. All these aspects are related. Each touches on the others, and a judgment about one aspect affects judgments about all the others. All must be considered and reconsidered at every stage in the project planning and implementation cycle. A major responsibility of the project analyst is to keep questioning all the technical specialists who are contributing to a project plan to ensure that all relevant aspects have been explicitly considered and allowed for. Here we will divide project preparation and analysis into six aspects: technical, institutional- organizational-managerial, social, commercial, financial, and economic. These categories derive from those suggested by Ripman (1964), but alternative groupings would be equally valid for purposes of discussion. Technical aspects The technical analysis concerns the project's inputs (supplies) and outputs (production) of real goods and services. It is extremely impor- tant, and the project framework must be defined clearly enough to per- mit the technical analysis to be thorough and precise. The other aspects of project analysis can only proceed in light of the technical analysis, although the technical assumptions of a project plan will most likely need to be revised as the other aspects are examined in detail. Good technical staff are essential for this work; they may be drawn from consulting firms or technical assistance agencies abroad. They will be more effective if they have a good understanding of the various aspects of project analysis, but technical staff, no matter how competent, cannot work effectively if they are not given adequate time or if they do not have the sympathetic cooperation and informed supervision of planning officials. The technical analysis will examine the possible technical relations in a proposed agricultural project: the soils in the region of the project and their potential for agricultural development; the availability of water, both natural (rainfall, and its distribution) and supplied (the possibilities PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 13 for developing irrigation, with its associated drainage works); the crop varieties and livestock species suited to the area; the production supplies and their availability; the potential and desirability of mechanization; and pests endemic in the area and the kinds of control that will be needed. On the basis of these and similar considerations, the technical analysis will determine the potential yields in the project area, the coefficients of production, potential cropping patterns, and the possibili- ties for multiple cropping. The technical analysis will also examine the marketing and storage facilities required for the successful operation of the project, and the processing systems that will be needed. The technical analysis may identify gaps in information that must be filled either before project planning or in the early stages of implementa- tion (if allowance is made for the project to be modified as more informa- tion becomes available). There may need to be soil surveys, groundwater surveys, or collection of hydrological data. More may need to be known about the farmers in the project, their current farming methods, and their social values to ensure realistic choices about technology. Field trials may be needed to verify yields and other information locally. As the technical analysis proceeds, the project analyst must continue to make sure that the technical work is thorough and appropriate, that the technical estimates and projections relate to realistic conditions, and that farmers using the proposed technology on their own fields can realize the results projected. Institutional-organizational-managerial aspects A whole range of issues in project preparation revolves around the overlapping institutional, organizational, and managerial aspects of projects, which clearly have an important effect on project implementa- tion. One group of questions asks whether the institutional setting of the project is appropriate. The sociocultural patterns and institutions of those the project will serve must be considered. Does the project design take into account the customs and culture of the farmers who will partici- pate? Will the project involve disruption of the ways in which farmers are accustomed to working? If it does, what provisions are made to help them shift to new patterns? What communication systems exist to bring farmers new information and teach them new skills? Changing custom- ary procedures is usually slow. Has enough time been allowed for farm- ers to accept the new procedures, or is the project plan overly optimistic about rates of acceptance? To have a chance of being carried out, a project must relate properly to the institutional structure of the country and region. What will be the arrangements for land tenure? What size holding will be encouraged? Does the project incorporate local institutions and use them to further the project? How will the administrative organization of the project relate to existing agencies? Is there to be a separate project authority? What will be its links to the relevant operating ministries? Will the staff 14 THE PROJECT CONCEPT be able to work with existing agencies or will there be institutional jealousies? Too often a project's organization simply builds up opposi- tion within other agencies; at the very least, the project analyst must be sure such friction is minimized. He should arrange for all agencies con- cerned to have an opportunity to comment on the proposed organization of the project and ensure that their views enter in the deliberation to the fullest extent possible. The organizational proposals should be examined to see that the proj- ect is manageable. Is the organization such that lines of authority will be clear? Are authority and responsibility properly linked? Does the organi- zational design encourage delegation of authority, or do too many people report directly to the project director? Does the proposed organization take proper account of the customs and organizational procedures com- mon in the country and region? Or, alternatively, does it introduce enough change in organizational structure to break out of ineffective traditional organizational forms? Are ample provisions included for managers and government supervisors to obtain up-to-date information on the progress of the project? Is a special monitoring group needed? What about training arrangements? Does the project have sufficient authority to keep its accounts in order and to make disbursements promptly? Managerial issues are crucial to good project design and implementa- tion. The analyst must examine the ability of available staff to judge whether they can administer such large-scale public sector activities as a complex water project, an extension service, or a credit agency. If such skills are scarce or absent, should this be reflected in a less complex project organization? Perhaps the technical analysis of the project should be consulted and the project design concentrate on fewer or less complex technological innovations. When managerial skills are limited, provision may have to be made for training, especially of middle-level personnel. In some cases expatriate managers may have to be hired, and this may raise other problems, such as the acceptance of the project manager by the local people and the loss of the experience the expatriate manager gained while working on the project when the manager leaves the country. In many instances it would be preferable if possible to design the organization of the project to avoid the need for management services of expatriates. In agricultural projects the analyst will also want to consider the managerial skills of the farmers who will participate. A project design that assumes new and complex managerial skills on the part of partici- pating farmers has obvious implications for the rate of implementation. If farmers with past experience limited to crop production are to become dairy farmers, enough time must be allotted for them to gain their new skills; the project design cannot assume that they will be able to make the shift overnight. There must be extension agents who can help farmers learn the new skills, and provision must be made for these agents in the organizational design and in the administrative costs of the project. PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 15 In considering the managerial and administrative aspects of project design, not only are we concerned that managerial and administrative problems will eventually be overcome, but that a realistic assessment is made of how fast they will be resolved. The contribution an investment makes to creating new income is very sensitive to delays in project implementation. Social aspects We have mentioned the need for analysts to consider the social pat- terns and practices of the clientele a project will serve. More and more frequently, project analysts are also expected to examine carefully the broader social implications of proposed investments. We have noted proposals to include weights for income distribution in the formal analytical framework so that projects benefiting lower-income groups will be favored. In the analytical system outlined in this book, such weights are not incorporated, so it is all the more important in the project design that explicit attention be paid to income distribution. Other social considerations should also be carefully considered to determine if a proposed project is as responsive to national objectives as it can be. There is a question about creating employment opportunities that is closely linked to, though not quite the same as, the question of income distribution. For social reasons, many governments want to emphasize growth in particular regions and want projects that can be implemented in these regions. The project analyst will want to consider carefully the adverse effects a project may have on particular groups in particular regions. In the past, the introduction of high-yielding seed varieties and fertilizers, coupled with the easy availability of tractors, has led to displacement of tenant farmers and has forced them into the ranks of the urban unemployed. Can the project be designed to minimize such effects, or be accompanied by policy changes that will? Changes in technology or cropping patterns may change the kind of work done by men and women. In some areas the introduction of mechanical equip- ment or of cash crops has deprived women of work they needed to support their children. Will a proposed project have such an adverse effect on the income of working women and their families? There are also considerations concerning the quality of life that should be a part of any project design. A rural development project may well include provisions for improved rural health services, for better domes- tic water supplies, or for increased educational opportunities for rural children. Project analysts will want to consider the contribution of alternative projects or other designs of essentially the same project in furthering these objectives. Those designing or reviewing projects will also want to consider the issue of adverse environmental impact (Wall 1979; Lee 1982). Irrigation development may reduce fish catches or increase the incidence of schisto- somiasis in regions where this snail-transmitted disease is endemic, and 16 THE PROJECT CONCEPT waste from industrial plants may pollute water. Project sites may be selected with an eye to preserving notable scenic attractions or to pre- serving unique wildlife habitats. It is far better to ensure preservation of the environment by appropriate project design than to incur the expense of retrofitting technology or reclaiming land after an environmentally unsound project has been implemented. Commercial aspects The commercial aspects of a project include the arrangements for marketing the output produced by the project and the arrangements for the supply of inputs needed to build and operate the project. On the output side, careful analysis of the proposed market for the project's production is essential to ensure that there will be an effective demand at a remunerative price. Where will the products be sold? Is the market large enough to absorb the new production without affecting the price? If the price is likely to be affected, by how much? Will the project still be financially viable at the new price? What share of the total market will the proposed project supply? Are there suitable facilities for han- dling the new production? Perhaps provision should be included in the project for processing, or maybe a separate marketing project for pro- cessing and distribution is in order (Austin 1981). Is the product for domestic consumption or for export? Does the proposed project produce the grade or quality that the market demands? What financing arrange- ments will be necessary to market the output, and what special provi- sions need to be made in the project to finance marketing? Since the product must be sold at market prices, a judgment about future govern- ment price supports or subsidies may be in order. On the input side, appropriate arrangements must be made for farmers to secure the supplies of fertilizers, pesticides, and high-yielding seeds they need to adopt new technology or cropping patterns. Do market channels for inputs exist, and do they have enough capacity to supply new inputs on time? What about financing for the suppliers of inputs and credit for the farmers to purchase these supplies? Should new channels be established by the project or should special arrangements be made to provide marketing channels for new inputs? Commercial aspects of a project also include arrangements for the procurement of equipment and supplies. Are the procurement proce- dures such that undue delays can be avoided? Are there procedures for competitive bidding to ensure fair prices? Who will draw up the specifi- cations for procurement? Finally, there are the two aspects of project analysis that are the primary concerns of this book, the financial and the economic. Financial aspects The financial aspects of project preparation and analysis encompass the financial effects of a proposed project on each of its various partici- PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 17 pants. In agricultural projects the participants include farmers, private sector firms, public corporations, project agencies, and perhaps the national treasury. For each of these, separate budgets must be prepared, along lines suggested in chapters 4 through 6. On the basis of these budgets, judgments are formed about the project's financial efficiency, incentives, creditworthiness, and liquidity. A major objective of the financial analysis of farms is to judge how much farm families participating in the project will have to live on. The analyst will need budget projections that estimate year by year future gross receipts and expenditures, including the costs associated with production and the credit repayments farm families must make, to deter- mine what remains to compensate the family for its own labor, manage- ment skills, and capital. Part of the income the family will receive may be in food that is consumed directly in the household, so a judgment must be made about this quantity and its value. Even if a family realizes a considerable increase in income or "net incremental benefit" by partici- pating in the project-as a result, say, of borrowing to purchase fertiliz- ers to increase rice production-its absolute income may still be so low that nearly all of the incremental production is consumed in the house- hold. Financial analysis must judge whether the family will then have sufficient cash to repay the production credit for fertilizer. If not, the analyst may have to make a policy judgment about how much to subsi- dize families with very low incomes. The farm budget becomes the basis for shaping the credit terms to be made available. The analyst must judge whether farmers will need loans to finance on-farm investment (and if so, what proportion the farmers should invest from their own resources) or to meet some production costs, and whether seasonal short-term credit should be provided for working capital to finance inputs and pay for hired labor. In tree-crop projects with long development periods, such as those for oil palm or citrus, the analyst must judge whether farmers will have adequate in- come to live on during the period before the trees begin to bear, or whether special financing arrangements must be made to sustain them. The objective of all these judgments is to shape credit terms that will be generous enough to encourage farmers to participate in the project, yet be stiff enough that the society as a whole can capture fairly promptly a share of the benefit from the increased production. This benefit can, in turn, be used to hasten growth by relending it to other farmers or by reinvesting it elsewhere in the economy. The analysis of farm income will also permit assessment of the incen- tives for farmers to participate in the project. What will be the probable change in farm income? What will be the timing of this change? How likely are price changes or fluctuations that could affect farm income severely enough that farmers will refuse to run the risk of participating in the project? What will be the effect of subsidy arrangements on farm income, and what changes in government policy might affect the income earned by farmers? Will new subsidies be needed to provide sufficient incentive for the project to proceed? 18 THE PROJECT CONCEPT A similar group of considerations applies to the financial analysis of private firms involved in the project. Will they have capital for expand- ing facilities? Will they have the working capital needed to carry inven- tories of farm supplies or stocks of processed goods awaiting sale? What return will the firms realize on their capital investment, and is this sufficiently attractive? An analysis of the financial aspects of the project's administration will also be needed. What investment funds will the project need and when? What will be the operating expenses when the project is under way? Will these expenses depend on budget allocations or will the project produce sufficient revenue to cover its administrative costs? Will changes in government policy be needed to finance the project, such as water charges levied in a new irrigation project? What about salary scales for project personnel? How will replacement of equipment be financed? Finally, the fiscal impact of some projects will need to be considered. Will the increased output yield significant new tax revenues, perhaps from an export tax? Will new subsidies be needed to encourage farmers to participate, and how much will subsidies have to grow as project implementation proceeds? If the administrative costs of the project are not to be met from revenues, how will this affect the national budget in the future? If the project investment is to be financed by a grant or by borrowing from abroad, while the operation and maintenance cost is to be financed from domestic resources, how will this affect the treasury? The methodology of discounted cash flow discussed in chapters 9 and 10 shows the way in which this financial analysis customarily is set up and the usual elements included in the cost and benefit streams. The methodology enables an estimate of the return to the equity capital of each of the various project participants, public or private. It is then a policy decision whether to change that return by income taxes, special lending terms, price subsidies, or any of the other tools open to society. Economic aspects The economic aspects of project preparation and analysis require a determination of the likelihood that a proposed project will contribute significantly to the development of the total economy and that its con- tribution will be great enough to justify using the scarce resources it will need. The point of view taken in the economic analysis is that of the society as a whole. The financial and economic analyses are thus complementary-the financial analysis takes the viewpoint of the individual participants and the economic analysis that of the society. But, because the same dis- counted cash flow measures (discussed in chapter 9) are applied in the financial analysis to estimate returns to a project participant and in the economic analysis to estimate returns to society, confusion between the two analyses easily arises. There are three very important distinctions between the two that must be kept in mind. These qualifications are summarized here and are taken up in greater detail later. PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 19 First, in economic analysis taxes and subsidies are treated as transfer payments. The new income generated by a project includes any taxes the project can bear during production and any sales taxes buyers are willing to pay when they purchase the project's product. These taxes, which are part of the total project benefit, are transferred to the government, which acts on behalf of the society as a whole, and are not treated as costs. Conversely, a government subsidy to the project is a cost to the society, since the subsidy is an expenditure of resources that the economy incurs to operate the project. In financial analysis such adjustments are nor- mally unnecessary; taxes are usually treated as a cost and subsidies as a return. Second, in financial analysis market prices are normally used. These take into account taxes and subsidies. From these prices come the data used in the economic analysis. In economic analysis, however, some market prices may be changed so that they more accurately reflect social or economic values. These adjusted prices are called "shadow" or "accounting" prices and in the analytical system recommended here are efficiency prices, as noted earlier. In both financial and economic analy- sis projected prices are used, so both rely to a substantial extent on what are, in effect, hypothetical prices. Third, in economic analysis interest on capital is never separated and deducted from the gross return because it is part of the total return to the capital available to the society as a whole and because it is that total return, including interest, that economic analysis is designed to esti- mate. In financial analysis, interest paid to external suppliers of money may be deducted to derive the benefit stream available to the owners of capital. But interest imputed or "paid" to the entity from whose point of view the financial analysis is being done is not treated as a cost because the interest is part of the total return to the equity capital contributed by the entity. Hence, it is a part of the financial return that entity receives. The methodology of comparing costs and benefits discussed in chap- ters 9 and 10 is the same for either an economic or a financial measure- ment of project worth, but what is defined as a cost and what is consid- ered a benefit are different. For the moment, it is enough to recognize that there is a difference between economic and financial analysis; we will discuss the differences in detail later. Policymakers must be concerned about the investment of scarce capi- tal resources that will best further national objectives. This is true whether the resources committed are being invested by the government directly or by individuals within the economy. The techniques of eco- nomic analysis presented here help identify those projects that make the greatest contribution to national income. The economic analysis in general allows for remuneration to labor and other inputs either at market prices or at shadow prices that are intended in the system recom- mended here to better approximate efficiency prices or "opportunity costs"-the amount we must give up if we transfer a resource from its present use to the project. The remainder is then compared with the capital stream necessary for the project. Those projects with the best 20 THE PROJECT CONCEPT return to capital, given the total resources available, are then selected for implementation. Inherent in this approach is the assumption that capi- tal is the most important limit to faster economic growth. What is not implicit in the approach is that capital alone causes economic growth. All the productive factors combined in a project contribute to the new income created, but the methods we will be discussing do not address themselves to the question of what the proportionate contribution of each factor is. We will apply the methods discussed here in economic (but not finan- cial) analysis in such a way that the economic analysis does not itself address the issue of income distribution. Although the analysis will determine the amount of the income stream generated over and above the costs of labor and other inputs, it does not specify who actually receives it. Part of a project's benefit is usually taken through taxes for purposes outside the project. Part is generally made available to compen- sate capital owners (including governments) for the use of their money. Part may become the basis of an indirect transfer of income, as is the case if farmers benefiting from a land settlement project are charged less than the full cost of establishing their holdings. The economic analysis applied in this book is silent about such distribution. Once the analyst knows what the more economically remunerative alternatives are likely to be, however, he can choose those that have better effects on income distribu- tion or other social objectives. Although the formal economic analysis will not decide issues of income distribution, the final decision on project investment will be an informed one that is then made in accord with views about income distribution. Many economists prefer analytical systems that explicitly include income distribution weights. They note that the system outlined here accepts in its formal structure the income distribution as it exists in a society and does not distinguish projects that have the most desirable effects on income distribution. They argue that simply choosing projects subjectively from among the higher-yielding alternatives is not enough. Systems using income distribution weights are used infrequently, however, and most project investment decisions follow the general prac- tice recommended here. Even economists who prefer using income dis- tribution weights often recommend applying them only to that small fraction of projects in which there is reason to believe the weights might change an investment decision. Readers wishing to consult a fuller treat- ment of income distribution weights in project analysis may turn to Little and Mirrlees (1974) and Squire and van der Tak (1975). Because economic analysis of a project as applied here tells us nothing about income distribution, it also tells us nothing about capital own- ership. The value of a capital asset arises from the right to receive the future income the asset generates. Since our method of economic analy- sis does not specify who in the economy is to receive the income that a project earns, it does not address the question of who owns the capital. Economic measures of project worth reached by means of the analytical system outlined here help determine the most attractive alternative from PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 21 the society's standpoint when the objective of the analysis is to increase national income. In this analytical frame, projects are equally valid whether the capital is to come from public revenue or private sources, whether there are income taxes or not, and whether the project is to be operated by public agencies or by individuals on their own behalf. In a manner analogous to the approach taken for income distribution, gov- ernments may then choose from economically remunerative projects those that lead to higher reinvestment and, hence, faster growth. Some economists, however, take economic growth generated by in- vestment, not income regardless of whether it is consumed or invested, as contituting at least part of their formal objective. If that is the case, then the source of the capital for a project makes a difference, as does who receives the benefits. A project financed by private sources that will consume all of the benefits will be less economically valuable than one in which all benefits accrue to a private individual who reinvests every- thing. Also, both will have values different from that of an identical project in which the benefit accrues to the government. As with income distribution weights, systems that weight capital sources or the invest- ment use of benefits become quite complex. Again, the reader may refer to Little and Mirrlees (1974) and Squire and van der Tak (1975). The Project Cycle There tends to be a natural sequence in the way projects are planned and carried out, and this sequence is often called the "project cycle." As was the case with aspects of project analysis, there are many ways-all equally valid-in which this cycle may be divided. Here we will divide it into identification, preparation and analysis, appraisal, implementa- tion, and evaluation. The sequence is adapted from an article by Baum (1978). Identification The first stage in the cycle is to find potential projects. There are many, many sources from which suggestions may come. The most common will be well-informed technical specialists and local leaders. While perform- ing their professional duties, technical specialists will have identified many areas where they feel new investment might be profitable. Local leaders will generally have a number of suggestions about where invest- ment might be carried out. Ideas for new projects also come from propos- als to extend existing programs. A program to develop water resources will probably lead to suggestions of additional areas for irrigation. An existing land settlement program will probably generate suggestions of new areas for settlement. Suggestions for new projects usually arise because some agricultural products are in short supply-or will be in a few years if production is not expanded or imports increased. The analysis may be based on general 22 THE PROJECT CONCEPT knowledge or upon a more systematic examination of market trends and import statistics. In addition, many countries have development banks intended to encourage growth of domestic industry. Often local firms will come to these banks with food processing proposals for which they are seeking finance. Such project-by-project approaches may overlook important potential initiatives in agricultural development. Most developing countries have an economic development plan of some formality that identifies sectors to be given priority and areas where investment is needed. These general- ized areas for priority are too vague to become the basis of investment themselves, but they lead to specific projects in crop or livestock produc- tion, land settlement, irrigation, food processing, expansion of export crop production, and the like. In the process of preparing an economic development plan, specific suggestions for projects usually will have come from the operating agencies responsible for project implementa- tion, and these agencies may be encouraged to proceed with detailed project preparation. Frequently, a separate sector survey of the current situation in agricul- ture will indicate what initiatives are needed. Such surveys may be undertaken with the help of an international agency or some agency for bilateral assistance. The sector survey will examine the current status of agriculture, project future needs for agricultural products over the next decade or so, and consider programs to improve the quality of rural life. It will examine prospects for expanding agricultural exports by consider- ing potential increases in production and the outlook for marketing possibilities, and it will identify the gaps in existing plans and programs. The survey will probably generate suggestions about new areas for in- vestment and the relative priority to be given different initiatives. It may even identify specific projects, especially larger ones, that merit consid- eration for future investment. Occasionally one hears that there is a lack of projects available for investment in developing countries. Usually there is no shortage of pro- posals for projects that have been identified. But there may be a shortage of projects prepared in sufficient detail to permit implementation. Preparation and analysis Once projects have been identified, there begins a process of progres- sively more detailed preparation and analysis of project plans. This process includes all the work necessary to bring the project to the point at which a careful review or appraisal can be undertaken, and, if it is determined to be a good project, implementation can begin. In the preparation and analysis of projects, consideration will be given to each of the aspects discussed earlier. The usual first step in project preparation and analysis is to undertake a feasibility study that will provide enough information for deciding whether to begin more advanced planning. The detail of the feasibility study will depend on the complexity of the project and on how much is PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 23 already known about the proposal. Quite often a succession of in- creasingly detailed feasibility studies will be needed. The feasibility study should define the objectives of the project clearly. It should explic- itly address the question of whether alternative ways to achieve the same objectives may be preferable, and it will enable project planners to exclude poor alternatives. The feasibility study will provide the oppor- tunity to shape the project to fit its physical and social environment and to ensure that it will be high yielding. Even at this early stage, the kind of financial and economic analyses discussed in this book should be brought into play. As projects are planned in greater and greater detail, the investment of time and money becomes more and more substantial, and the expectations of vested interests continue to grow. Being faced only at a late stage in the plan- ning process with the decision to accept or reject a project on financial or economic grounds is obviously an uncomfortable position to be in. Far better that the financial and economic analyses enter early in the plan- ning process, so that the feasibility studies introduce these aspects in the project plan. The staff needed to work on feasibility studies will depend on how complex the studies are. To start, a single staff member may make a preliminary estimate in a relatively short time. Later the services of a small team, or perhaps outside consultants, may be engaged. Once the feasibility studies have indicated which proposed project will likely be worthwhile, detailed planning and analysis may begin. By this time the less promising alternatives will have been eliminated, but even at this point the selected project will continue to be redefined and shaped as more and more becomes known. This is the stage at which detailed studies will commence-the carefully done soil surveys, the detailed hydrological analyses, the thorough examination of cropping patterns, the month-by-month estimates of labor requirements, the detailed farm budgets, and so forth. Again, all the aspects of analysis noted in the last section must be considered and correlated so that realistic estimates can be made of how the project might be implemented and of its likely income-generating capacity. Detailed planning takes time, often a year or two or longer for complex agricultural projects. It may also be quite expensive. In agriculture, preparing the detailed project plan may well cost 7 to 10 percent of the total project investment. Yet thorough preparation increases a project's efficiency and helps ensure its smooth implementation in the future, so that the additional time and money required will probably be returned many times over by the increased return from the investment. Hastily prepared, superficial analyses will very likely yield projects that fall behind schedule, have lower returns, and waste scarce resources. Preparation of the plan should itself be planned so that delays can be avoided and resources conserved. The timing of special studies needs to be considered, and the services of outside consultants should be sched- uled so they will be available when needed-but not before the consul- tants' specialized knowledge can be used. The project may be prepared 24 THE PROJECT CONCEPT by a special team assembled for the purpose and given sufficient time and resources, or it may be prepared by a consulting firm or a technical assistance agency such as the Investment Centre of the Food and Agricul- ture Organization (FAO). Appraisal After a project has been prepared, it is generally appropriate for a critical review or an independent appraisal to be conducted. This pro- vides an opportunity to reexamine every aspect of the project plan to assess whether the proposal is appropriate and sound before large sums are committed. The appraisal process builds on the project plan, but it may involve new information if the specialists on the appraisal team feel that some of the data are questionable or some of the assumptions faulty. If the appraisal team concludes that the project plan is sound, the invest- ment may proceed. But if the appraisal team finds serious flaws, it may be necessary for the analyst to alter the project plan or to develop a new plan altogether. If a project is to be financed by an international lending institution such as the World Bank or by a bilateral assistance agency, such an external lender will probably want a rather careful appraisal even if it has been closely associated with earlier steps in the project cycle. The World Bank, for example, routinely sends a separate mission to appraise proposed projects for which one of its member governments intends to borrow. Implementation The objective of any effort in project planning and analysis clearly is to have a project that can be implemented to the benefit of the society. Thus, implementation is perhaps the most important part of the project cycle. It is also clear, however, that considerations of implementation and project management are far too extensive for discussion here. Yet there are some aspects of implementation that are of particular relevance to project planning and analysis. The first, obviously, is that the better and more realistic a project plan is, the more likely it is that the plan can be carried out and the expected benefit realized. This emphasizes once again the need for careful attention to each aspect of project planning and analysis. Second, project implementation must be flexible. Circumstances will change, and project managers must be able to respond intelligently to these changes. Technical changes are almost inevitable as the project progresses and more is known about soils, their response to nitrogen applications, susceptibility to waterlogging, and the like. Price changes may necessitate different cropping patterns or adjustments in inputs. Other changes in the project's economic or political environment will alter the way in which it should be implemented. The greater the uncer- tainty of various aspects of the project, or the more innovative and novel PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 25 the project is, the greater the likelihood that changes will have to be made. Even as project implementation is under way, project managers will need to reshape and replan parts of the project, or perhaps the entire project. All of the general considerations we have discussed, as well as the analytical tools we will take up in detail in the following chapters, must be brought into play once again. Implementation is a process of refine- ment, of learning from experience-in effect, it is a kind of "mini-cycle" within the larger project cycle we have outlined. Project analysts generally divide the implementation phase into three different time periods. Thefirst is the investment period, when the major project investments are undertaken. In agricultural projects this usually extends three to five years from the start of the project. If the project is to be financed with the assistance of a loan from an external financing agency, the investment period may coincide with the agency's period for loan disbursements. Then, as its production builds up, the project is spoken of as being in the4development period. This often takes an addi- tional three to five years, but it may be extended if the project involves cattle herds, tree crops, or other investments with long gestation. The duration of the development period reflects not only physical factors but also the rate of adoption at which farmers take up new techniques. Once full development is reached, it continues for the life of the project. Usually the project life is keyed to the normal life of the major asset, although for practical reasons a project life rarely exceeds twenty-five to thirty years. Both the financial and economic analyses of the project relate to this time horizon. Evaluation The final phase in the project cycle is evaluation. The analyst looks systematically at the elements of success and failure in the project ex- perience to learn how better to plan for the future. Evaluation is not limited only to completed projects. It is a most important managerial tool in ongoing projects, and rather formalized evaluation may take place at several times in the life of a project. Evaluation may be under- taken when the project is in trouble, as the first step in a replanning effort. It may be appropriate when a major capital investment such as a dam is in place and operating, even though the full implementation of the plan to utilize the water and power is still under way. Careful evaluation should precede any effort to plan follow-up projects. And, finally, evalua- tion should be undertaken when a project is terminated or is well into routine operation. Evaluation may be done by many different people. Project manage- ment will be continuously evaluating its experience as implementation proceeds. The sponsoring agency-perhaps the operating ministry, the planning agency, or an external assistance agency-may undertake eval- uation. In large and innovative projects, the project's administrative structure may provide a separate evaluation unit responsible for moni- toring the project's implementation and for bringing problems to the 26 THE PROJECT CONCEPT attention of the project's management. Often the evaluation unit will include persons with planning skills who enable the unit to take part in any necessary replanning. The evaluation unit may also be responsible for planning follow-up projects. In many instances, the project's management or the sponsoring agency will want to turn to outside evaluators. University staff may be well suited to undertake the task. Whoever does the evaluation will want to read the relevant documents carefully and then have extensive conversa- tions with those who have had a part in the project-planners, project managers, operating staff, farmers participating in the project, or local people affected by the project. The extent to which the objectives of a project are being realized provides the primary criterion for an evaluation. The objectives cannot be accepted uncritically, however; the inquiry should consider whether the objectives themselves were appropriate and suitable. The evaluators will want to know if these goals were made clear to the planners and to project management. The project plan should be reviewed to see if it was an appropriate one in light of the objectives set forth. Each objective should be examined to determine whether it was considered carefully and whether appropriate provision for it was made in the project plan. Was the technology pro- posed appropriate? Were the institutional, organizational, and manage- rial arrangements suited to the conditions? Were the commercial aspects properly considered? Were the financial aspects carefully worked out on the basis of realistic assumptions, and were the economic implications properly explored? How did the project in practice compare with each aspect of the project analysis? The evaluation should consider the response of project management and the sponsoring agencies to changing circumstances. Did manage- ment respond quickly enough to changes? Was its response carefully considered and appropriate? Did the institutional and organizational structure in the project permit a flexible response? How could the proj- ect's structure be altered to make the response to change more flexible and appropriate in the future? From the evaluation should come carefully considered recommenda- tions about how to improve the appropriateness of each aspect of the project design so that plans for project implementation can be revised if the project is ongoing and so that future projects can be better planned if the project evaluated has been completed. Accuracy of Agricultural Project Analyses Since agricultural project analyses are intended to become the basis for investment decisions, just how accurately do they foretell project results? The World Bank systematically reviews the performance of projects for which it lends and publishes the results annually. These reviews PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 27 generally are undertaken at the end of the implementation phase of the project. The most recent report, from which this section draws exten- sively, reviewed thirty-two agricultural projects for which performance audits were completed in 1980 (World Bank 1981a). Although the par- ticular projects reviewed by no means constitute a random sample, the results of the review confirm earlier trends and may be taken as generally indicative of all agricultural projects the World Bank finances. The proj- ects included those for credit, irrigation, tree crops, fisheries, food crop production, livestock, storage, drought relief, and technical assistance. Economic effects Economic rates of return had been calculated at the time of appraisal for twenty-four of the projects included in the 1981 review and were reestimated at the time of the performance audit. (The other eight proj- ects were either canceled before implementation or were of a nature- such as drought relief-that no rate of return was calculated.) The reesti- mates, of course, were done at the end of the implementation phase and so still included projections for the balance of the project life. Fourteen had rates of return that were within 2 percent of the rate estimated at appraisal or were greater than the appraisal estimate, and ten fell more than 2 percent below the rate of return estimated at appraisal. Of the twenty-four projects, nineteen had reestimated rates of return at the time of the review at or above 10 percent, a minimum acceptable rate in most developing countries. The rates of return alone, however, can be some- what misleading. Several projects varied substantially from what was anticipated at the time of appraisal, but the variations were offsetting. One project that had an acceptable rate of return when reestimated at the time of the performance audit, for example, increased food grain output only about half as much as anticipated, but increases in grain prices offset the production shortfall and gave the project an acceptable rate of return. For all projects taken together, the weighted reestimated return was 20 percent, well in line with the estimates of earlier years. Credit projects performed the best. They had an average rate of return of 26 percent, the lowest cost overruns and lower than average time overruns, and a clear advantage in reaching poor farmers. The largest subgroup, irrigation projects, had an average rate of return of 22 percent. In line with the results of previous surveys, "decentralized, small-scale groundwater and lift irrigation projects where each farmer develops his own potential were relatively smoothly implemented, resulted in lower costs per hectare, and proved extremely profitable. On the other hand, larger, centralized 'projects supported by detailed studies and designs and im- plemented by specialized agencies were beset with problems, were com- pleted late and at much higher costs, resulted in high costs per hectare developed, and proved modestly profitable" (World Bank 1980, p. 29). The tree-crop projects had reestimated returns of 17 percent, substan- tially in line with the consistently good performance noted for this kind 28 THE PROJECT CONCEPT of project in earlier years. In the five projects that had unacceptable rates of return, the failure could generally be traced to a combination of inappropriate technology and poor management. Effect on incomes of rural poor The World Bank has been particularly pleased that performance re- views of the projects it finances demonstrate that agricultural projects focusing on small farmers and the rural poor perform as well as other projects in the sector. The 1980 review showed that rural development projects-those specifically designed to reach large numbers of small farmers and the rural poor-had an average return of 17 percent com- pared with the average of 20 percent for all other kinds of agricultural projects. "They have also reached ten times as many farmers per project, at a fraction of the cost of serving medium and larger farmers. Although the absolute amount of the income increases obtained through small farmer projects were a fraction of those received by medium and larger farmers, they were larger in relative terms . . ." Because they were received by so many farmers, "they had a substantial impact on income distribution" (World Bank 1980, p. 18). Implementation experience Of the thirty-two projects reviewed in 1981, only five were completed without delay or with delays of 10 percent or less.(This is much below the experience reported in earlier years, when about a third of the projects were completed on time.) Of the twenty-seven projects experiencing serious delays, fourteen were completed within 50 percent more time, six were completed in from 50 to 100 percent more time, and seven took more than twice as long to complete as scheduled at appraisal. The experience of cost increases paralleled that of time delays. The average cost increase was 29 percent. Of the thirty-two projects, only twelve were completed with cost increasesof 10 percent or less, five were within the range of 10 to 59 percent cost overrun, six were in the range of 50 to 100 percent overrun, and five cost twice or more the appraisal estimate. The major reason for delay, which affected eight projects, was poor performance by executing agencies or contractors. The second most common cause, which affected six projects, was delay caused by bidding and procurement procedures. The third most common cause was delay due to unanticipated technical problems. As had been the experience in earlier reviews, the most common reasons for cost increases were general price inflation and underestimation of unit costs at appraisal, but other reasons included increases in the scope of a project and in the total number of input units required. Delays in project implementation aggra- vated the effects of inflation. Among subsector averages for timing of completion, tree-crop projects on the whole were completed on time or with very little delay, followed PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 29 by credit projects, with an average time overrun of 31 percent, and livestock and irrigation projects, with an average delay of about 50 percent. The most serious delays were encountered in emergency reha- bilitation projects, which took about twice as long as anticipated, and in technical assistance projects, which took 78 percent longer on the aver- age than planned. No regional concentration of implementation delays was apparent. The incidence of cost increases by subsector showed that the largest increases were in irrigation projects, which had an average cost overrun of 71 percent, an experience in line with that of earlier reviews. Time and cost overruns were thus both substantial in irrigation. Agricultural credit, area development, emergency relief and rehabilitation, and tech- nical assistance projects were completed without, or with minor, cost increases; livestock projects had moderate increases; and tree-crop proj- ects had substantial cost increases, on average 57 percent. Of the thirty-two projects reviewed, twenty-seven were changed, for- mally or informally, during implementation. The most important causes were poor or incomplete original design, which affected fifteen cases; changes in government policies and strategies, which affected eleven cases; beneficiary preferences different from those anticipated, which affected seven cases; and impending cost overruns, which affected seven cases. Most projects were affected by a combination of these factors. Shortcomings in design appear to have been a result of projects' being approved without sufficient preparation. Not all project changes during implementation, however, are undesirable or avoidable. Some projects are designed to be of a pilot nature, and in other projects changes in the price environment lead logically to changes in the mix of products. As the review noted, "project design should be sufficiently well developed to allow for immediate and straightforward project implementation but flexible enough to allow for adaptation without causing undue delay, wasted expenditures, or cost increases, all of which might reduce" the benefit of a project (World Bank 1981 a, p. 34). Why Agricultural Project Analyses Prove Wrong When an agricultural project analysis proves to be a poor predictor of the actual outcome of a project, it may be that the project design or implementation is at fault, or it may be that the project analyst has done a poor job of incorporating a good project design in an analytical framework. Problems of project design and implementation The same World Bank performance audits used in the previous section to judge the accuracy of agricultural project analyses in estimating economic returns also examine the reasons for poor performance (World Bank 1980 and 1981a). In the most recent of these reviews and in an 30 THE PROJECT CONCEPT earlier summary of project experience prepared by Olivares (1978), the most common reasons agricultural projects run into problems of imple- mentation may be grouped into five major categories: (1) inappropriate technology; (2) inadequate support systems and infrastructure; (3) fail- ure to appreciate the social environment; (4) administrative problems, including those of the project itself and of the overall administration within the country; and (5) the policy environment, of which the most important aspect is producer price policy. INAPPROPRIATE TECHNOLOGY. Given the use and availability of land in most developing countries, increased crop production generally must depend on greater crop yields rather than on area extension. Thus, improved technology is a key element in most agricultural projects. Among the thirty-two projects in the 1981 review, as many as twenty-two depended on technological packages substantially new to the farmers in the project area. The introduction of new technology was concentrated in irrigation, tree-crop, rural development, and fisheries projects. New technologies included a range of innovations. For irrigation proj- ects, a farm input package with water as the main input was followed by improved seeds and further complemented by fertilizers and sometimes other inputs and improved cultural practices. For tree-crop projects, innovations took the form of improved cultural practices and equipment, early-maturing and high-yielding hybrids, and chemical instead of manual weed control. Rural development projects introduced farm in- put packages similar to those for irrigation; livestock projects empha- sized pasture improvement; fisheries projects introduced improved fishing techniques and boats and equipment; and the storage project provided for modernized grain storage, pest control, and transport. In fifteen of the projects reviewed, information was available about the effect of the technological innovation. In general, new technology was successful; eleven projects achieved or surpassed target yields. The ma- jor success factors appear to have been the appropriateness of the tech- nology proposed for the given local conditions, the complementarity of recommended inputs, and the strength of the support systems (including research and extension to adapt the offered technologies to suit changing circumstances; see the section on infrastructure and support systems, below). In other projects, poor performance could be traced to in- appropriate technology. In one project that failed to achieve the target yield, the failure of small farmers to apply more fertilizer was attributed to their desire to minimize risk by maximizing the return on a given investment rather than the return per hectare. In another project, farm- ers were ready to apply selected low-risk, productivity-raising inputs but not the entire package of recommended cultivation techniques. High density and early sowing, in particular, were largely rejected. Farmers preferred to avoid risk by staggering sowing dates and planting a larger number of low-density plots. The review concluded that "new technolo- gies for dry farming should be more risk-reducing than those for irrigated PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 31 farming where assured water supply eliminates much of the usual risk" (World Bank 1981a, p. 26). INFRASTRUCTURE AND SUPPORT SYSTEMS. Of the thirty-two projects re- viewed in 1981, twenty-eight could be viewed as part of an essential chain of support systems and infrastructure. The links in the chain include the relevant research, extension services, credit availability, input supply, and product markets; the importance of the chain lies in the introduction of technical packages, an essential element in most agricultural projects. These packages must first be developed and tested through research, adapted to the ecological conditions found in the project, and then delivered to the farmers through an adequately staffed, qualified, and motivated extension service that can then provide feed- back for further research. In most cases, farmers do not have sufficient funds to purchase the recommended packages, and credit has to be made available. The input supply has to be organized, and this includes intro- duction of improved high-yielding varieties, provision of better livestock breeds, and the strategic location of stores where fertilizers, pesticides, and machinery such as pumps and their spare parts are available. Fi- nally, the marketing of farm produce has to be organized in a manner that provides sufficient incentives to producers and avoids costly losses. As may be expected, the content and detail of the support systems and infrastructure vary widely from project to project. In the projects re- viewed, marketing systems received the most frequent attention (twenty out of twenty-eight projects), research support was given significant emphasis (seventeen projects), and credit and extension support received equal treatment (about one-half of the twenty-eight projects). Input supply systems received the least attention (one-third of the projects). Deficiencies in the back-up research component were noted at ap- praisal in eight projects; in all cases a research component was included in the project, or arrangements were made for supporting research to be undertaken by an appropriate research group. In six of the eight projects, the research arrangements proved effective. In two cases, the projects suffered from lack of specific research, although both of these had in- cluded a research component in the original project design. A major problem in agricultural and rural development projects is organizing farmers efficiently to provide them services, especially in their adapting new technology. The appropriate organization of farmers into self-help schemes is especially difficult, and the record of coopera- tives has not been good. There are no easy solutions to these problems. A critical factor is to recognize at the project design stage that the small farmer will not take risks that could involve losing his livelihood and that some form of organizing farmers into self-help groups is essential to economical provision of government service. Extension services were to be provided by the project unit in nine projects included in the 1981 review; in all but one of these the national extension service was judged to be inadequate. In general, these exten- 32 THE PROJECT CONCEPT sion efforts were effective, but in two projects the extension effort failed to reach a minimum level of performance. In one project centered on grain production, output increased by only half the amount projected at appraisal. In the other, poor administration, including a failure to pro- vide adequate extension, combined with poor design and unfavorable government policies to produce a negative return. Credit was the major instrument for development in thirteen of the twenty-eight projects. It was used to promote a technical package in eight projects and other investment expenditures in the remaining five. The balance of the projects, with one exception, were clearly judged not to require credit. Only a single input was supplied through the project in a number of cases, the full complement being provided in others. For the most part, inputs were supplied by the project units in estate projects where pro- duction was under full control of the project unit, or where small growers received credit in kind and were expected to follow specified production practices. In other projects that had an input supply component, the private sector met the needs. Lack of marketing facilities is among the most difficult factors to provide for or change through projects directed mainly toward produc- tion. The principal marketing component in the projects was for the project unit to purchase the output of small producers. One project provided credit to market centers and cooperatives so that they could in turn provide advances to farmers for production and living expenses. One fisheries project provided cold storage facilities to improve market- ing. Of the twenty-eight projects where infrastructure and support sys- tems were central, only two were judged at audit to have been affected by lack of marketing facilities. FAILURE TO APPRECIATE THE SOCIAL ENVIRONMENT. Sometimes the tech- nical aspects of a project may be fairly well foreseen, but the social effects inadequately assessed. In one West African rice intensification project, progress was initially much slower than anticipated. A study revealed that in this area rice was produced by women, but that the credit needed for new inputs was channeled through institutions of which only men were members-and the men were not about to borrow for a woman's crop. When the national credit agency set up credit channels that could lend directly to women, implementation accelerated markedly. In another African project, in an area of traditional extended family groupings a limit was established on individual loans for crop inten- sification. As a result, instead of the head of the family, who was responsi- ble for allocating land to be cultivated, being able to borrow on behalf of the whole family, individual cultivators had to seek credit. Borrowing directly for production on their own account gave the cultivators a new, independent income. The impact of this change-whether good or bad- on the social structure of the area was not even considered by the analyst when the project was formulated (Olivares 1978). PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 33 ADMINISTRATIVE PROBLEMS. The experience of the projects reported in the 1981 review reinforced conclusions about administrative structures reached in earlier reviews. Among the projects in the 1981 review, the performance level was high in ten of the twenty-two completed projects in which special efforts had been made to strengthen administrative and technical capabilities; partial success was achieved in another six; and the results were negligible in four. In line with the experience of previous years, there was frequently a close association between institutional and project performance. On the one hand, the three worst performers in- cluded in the 1981 review-all with negative rates of return-shared a pattern of weak management that was not corrected as implementation proceeded. On the other hand, nine of the best-performing projects re- viewed in 1981 were implemented by agencies that were noted for good administration or that made special efforts to improve their administra- tive effectiveness during the implementation period. In at least one instance, an effort to improve the effectiveness of implementation paid dividends by enabling the agency to overcome initial administrative and design difficulties. Past project performance reviews have led to the conclusion that "spe- cially created project implementation units [have] an isolated and precarious existence, usually [run] into difficulties, and should, as far as possible, be avoided as a temporary device to by-pass institutional weak- nesses and to insulate . . . projects from the larger institutional environ- ment" (World Bank 1981a, p. 27). Staffing is a major problem in almost all development projects. Dif- ficulties can be institutional-for example, restrictive governmental sal- ary policies, civil service procedures, and promotion regulations-or can take the form of shortages of certain kinds of skilled people. One solution is often the use of consultants. Yet there frequently are difficulties be- tween local project personnel and external consultants. Other common personnel problems include incompetent staff, ineffective training, high turnover, and poor matching of specific individuals with specific jobs. Seven of the projects in the 1981 review made use of coordinating committees as an institutional instrument. As had been the case in earlier reviews, the experience was less than satisfactory. On the basis of this experience, the review concluded that "(1) high-level coordinating committees are generally not effective; (2) if formal coordination is needed, it should be established at the required technical or administra- tive level; and (3) a project unit within an existing organization may usefully undertake coordinating administrative functions" (World Bank 1981a, p. 28). Delays in procurement- will result in shortages of material, especially of foreign equipment. Sometimes delay is due to inadequate foresight and forward planning and sometimes (particularly in rural development projects) to unfamiliarity with procurement practices. The importance of timely procurement must be emphasized from the first stages of the project cycle and should be prominently included in the detailed imple- mentation schedules. 34 THE PROJECT CONCEPT Government administrative and managerial practices are at least as important to project implementation as the skills of project managers. If the central or local administrative processes are inadequate, the projects will encounter delays and, almost always, consequent cost increases. Common problems include slow and cumbersome decisionmaking, poor systems to authorize disbursement of project funds, ill-defined organiza- tional arrangements, inadequate coordination among different agencies involved with a project, and, sometimes, government structures that deny appropriate authority to the project manager. POLICY ENVIRONMENT. Every project must be implemented within a framework of policies set by the government. If these are such that farmers' incentives are destroyed or other serious impediments are put in the way of project implementation, then the project cannot be ex- pected to achieve satisfactory results. The overriding importance of producer prices in affecting producer income, production levels, and economic efficiency was confirmed in the 1981 review. Prices contributed to expansion of production by encourag- ing farmers to participate in the project, to expand areas devoted to the project crops, and to use more inputs and thereby increase yields. The 1981 review analyzed project performance in relation to prices in eigh- teen projects. Eleven out of thirteen projects implemented under favor- able prices achieved or surpassed their production objectives; all five under unfavorable prices failed to do so. Projects implemented under favorable prices offered an average rate of return at reestimate of 22 percent, whereas those under unfavorable prices averaged 10 percent. The issue of producer prices was developed in more detail in the 1980 review (World Bank 1980). Producer price information was available from twenty-seven projects. Of those in which producer prices were judged unfavorable, 33 percent reflected low world market prices about which the individual country could do little, 25 percent had producer prices much below world market levels because of government decisions about price policy, and in the remaining 42 percent there was no direct link between the producer prices and the world market. Depressed world market prices for dairy produce affected one agri- cultural credit project in a North African country. Local milk production had to compete with reconstituted milk, which was imported at very low prices. This hampered the dairy farm component of the project because farmers were unwilling to invest in uncompetitive dairy enterprises. In a large irrigation project in Latin America, about 70 percent of the cropped project area was originally planted with cotton when the project began operation in 1967 because farmers were encouraged by very high prices and readily available credit. As international prices declined, the area planted in cotton dropped to 40,000 hectares in 1973 and climbed back to 62,000 hectares in 1978 when the prices recovered again, but the area remained substantially below the 100,000 hectares projected at appraisal. PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 35 Government policy to tax farmers producing groundnuts and cotton kept the producer prices much below world market levels in two projects in one East African country, and the area under these crops fell 40 to 50 percent short of appraisal estimates. Another example comes from a tobacco project in another country in the same region. Producer prices for tobacco in the country increased 26 percent during the 1972-78 period, while world market prices went up 75 percent and the price of maize, a competing crop, by 226 percent. Government policies to tax export crops and equalize average returns on labor for all crops caused the farmer's share in the selling price of processed tobacco to decline from 66 percent in 1965-66 to 37 percent in 1977-78. As a result, tobacco production stagnated, and the project itself became economically viable only because farmers switched to higher-valued maize production. Other projects suffering from low producer prices not directly linked to world market prices included: a commercial farming project in a third East African country in which poor handling of tobacco resulted in low quality and low prices; a project with a vegetable component in West Africa in which the project authority limited tomato production by paying low prices to farmers; and a Central American livestock project in which the freezing of milk prices caused most of the specialized dairy farms around the capital city to close down permanently. In contrast, profitable producer prices-prevalent in only about 30 percent of the projects included in the 1980 review-had strong positive effects. In one livestock project, for instance, milk production after four years was already 50 percent of the target for full development after eight years, mainly because of the government's pricing policy for milk rela- tive to beef. A West African cotton project similarly benefited from higher-than-expected world cotton prices. Although production targets were not met, farm income objectives were achieved, and cotton export earnings and targets for economic return were exceeded. Such experiences, repeated over and over, emphasize the importance of taking price policies into account as a factor when designing and implementing agricultural projects. Problems of poor project analysis When a project analysis has failed to anticipate the outcome of a project investment, a common reason appears to have been simply poor preparation of the analysis. A number of such cases were analyzed in a review prepared by Olivares (1978), from which this section draws heavily. Underestimated costs were common, either as a result of the analyst's being systematically optimistic about cost or making an especially poor estimate about the cost of particular components. Sometimes a compo- nent necessary for proper functioning of the project or an activity critical to the project was omitted from the cost estimates, even though in the same analysis it was noted that it would be essential to proper execution 36 THE PROJECT CONCEPT of the project. In the projects reviewed, components commonly omitted from the cost estimates (although not necessarily from the project and closely associated activities planned by the technicians) included agri- cultural extension to help farmers adopt new practices, training pro- grams for project technicians, agronomic and livestock trials, com- plementary infrastructure such as roads or market facilities, and the expansion of the credit availability critical to the farmers' ability to adopt new techniques based on purchased inputs. Excessively optimistic projections frequently were made during proj- ect preparation. In the projects reviewed, overestimates were common in projecting areas to be brought under cultivation, yields, rates of increase in livestock herds, and total production in the project area. The most common of these overestimates proved to be in cultivation intensity in irrigation projects and in the calving rate in cattle production projects. Project analyses frequently were too optimistic about the rate at which new cultivation practices would be adopted with irrigation, about the rate at which new areas would be brought under methods of improved cultivation, and about the rate at which the new technology could be applied under farm conditions. When analyses of crop or livestock projects in rainfed areas did not predict the outcome well, the reason was often a failure to consider explicitly the variability of the climate and thus to overestimate returns. The analysis for one project undertaken in the Sahel region of Africa made no allowance for the variability of the climate, although the same analysis noted the likelihood of one or two dry years about once every five to seven years. The drought of 1973-75 paralyzed the project and forced planners to reevaluate and completely redesign the project. One live- stock project in a Mediterranean country assumed that the weather during the project life would be "normal," despite the fact that in this region almost no year approaches this statistical computation. Nearly every particular year in the region is either too dry or too rainy, with the rains coming either too early or too late, and so forth. Naturally, making no allowance for this variability led to an overestimate of the project's yield and its attractiveness to the farmers involved. Project evaluations commonly assumed too optimistic a calendar for project implementation. The analyses often did not test the effect on the project return of delays in getting the project under way-almost a normal situation in agricultural projects in general-or of delays in project execution at a later stage. The return from investment in the agricultural projects examined was found to have been overestimated sometimes because the analysis failed to account for an adverse effect of the investment on production, either in the project area or elsewhere. In one project in Latin America, the main canals were lined to prevent water loss and to increase water delivery to the field. The analyst failed, however, to account for the irrigation of adjacent areas by wells recharged by seepage from the canals. The re- duced output from these adjacent areas once the project was under way was not deducted from the benefits in the analysis. Of course, this led to an overestimate of the benefit from the irrigation project. Several irriga- PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 37 tion projects in Asia were found to have reduced the spawning grounds of commercially important fish. The result was that much of the benefit from expanded irrigation was offset by a fall in fish production and reduced income for thousands of fishermen. Project analysts often made errors when translating technical assump- tions into projections of project performance. In one project it was assumed that 80 percent of the projected increase in area to be cultivated using more intensive technology would be reached in the first year, with the remaining 20 percent realized over the succeeding four years. In another project, expansion of the irrigated area was assumed to take place before the basic irrigation construction was to have been com- pleted. In yet another case, the analyst assumed that fruit trees would reach full production the year they were planted. Such obvious errors could have been avoided just by cross-checking with the technical spe- cialists as the analysis proceeded. Steps in Project Analysis Preparing a project analysis is anything but a neat, continuous process with well-defined steps, each of which is completed before the next and never retraced. Instead, the whole process is iterative; that is, the analyst must continuously go back and adjust earlier decisions in the light of what is learned from later analysis. In general, the process begins with an idea about the broad nature and objectives of a proposed project that has been supplied by the political or planning process. We will know, for example, that we are expected to prepare an irrigation project in a particular area, or a marketing project to reduce seasonal fluctuations in the price of an agricultural product, or an extension of an existing land settlement project. The next step is to examine carefully the pertinent technical relations on which to base the technical planning. We then begin to price these technical requirements and to develop some projec- tions of inputs and outputs as the basis for the financial analysis. These financial prices are then adjusted to give economic values on which to base the economic analysis and to judge the project's contribution to the national income. At each step we must consider the institutional, organi- zational, and managerial aspects and the social effects. And, of course, at each step we may want to go back and revise earlier parts of the plan. The flow chart in figure 1-1 depicts this process schematically. The sequence of topics in this book generally follows the order of the analytical process in preparing a financial, and then an economic, analy- sis of an agricultural project. We will not consider in detail the technical, institutional-organizational-managerial, social, or commercial aspects of preparing a project. Instead, we will assume that such preparations are already well in hand and that specialists knowledgeable in these matters can be easily consulted in the course of the analytical process. We will turn first to what constitute costs and benefits in agricultural projects (chapter 2). Then we will proceed to how one can find market prices on which to base the project analysis (chapter 3). From these topics 38 THE PROJECT CONCEPT Figure 1-1. Formulation and Analysis of Agricultural Projects Technical aspects Soils Water avadability Rainfall Irrngatson and drainage Crops and vartenes Livestock species Physical inputs Mechanizaion Pest control Yields and production coefficent Cropping patterns and frequency Marketing and storage facilitues Processing systems Business negotiations Supply bids Purchase offers Participation terms Institutionalrgan-tional Tax ancentves management aspects Customs and culture offamers Extent of new cultivation practices C,and skills Financing plan Communication system Sources of funds Rates of acceptance Lg- adsoterm loans Land tenun and size of holding a rerloan Use of local institutions Cre t rns Management ability of farmer S es d overnmnt budget Government and agency policies Social aspects Financial benefits and costs Income distribution Project planning F physical units x market prices) Job creationcaio Farm budgets Regional development FampasIno Disotive socal effects Herd prec tios-5l Role o wo me se Family income Improvement ofrural living Timing and phasing Enterpnse budgets Environmenstal impact Transport arrangement Capital investment Engneenng Revenues Project organiration Cash operating expenses C e-cAdministration Salary, general and admin- Maeted demad sforecasts Eension source strave espenses M0`keteM2a'.sTZforast,Credt sytemNon1casivespenses Marketing system Consultants Nono nyertingncome Inputs Monitoring spenss Gutputs Manose Taxes Financing Stafgng pattern Equity Price policies Management Loans Training Accounts payable and receivable Commercial plans Financing terms Procurement and dividend policy Financial aspects Input supplies Inventory needs Market prices Marketing and processing Preproduction Income Inventories and launching costs Incentive effects Sales terms Government budgets Financing policies Start-up Recovery rates ofintituionsBudget needs Taxes S.bs,dres Import and export party prices Economic aspects Shadow exchange (rates Oand corversion factor,) Economic benefits and costs show p,cs)(a (physical unit a e e F oportunity costs) i_________ent___________ Farm budgets Nontraded items Enterprise budgets Import and esport panty prices Government budgets Source: Adapted from Frank L. Lamson-Scribner and Robert B. Youker, "The Project Cycle and the Project Appraisal Process," trainng material of the Economic Development Institute (EDI), CN-419 (Washington, DC World Bank, 1975), exhibit 5. PROJECTS, THE CUTTING EDGE OF DEVELOPMENT 39 Fmnancial pFinancial benefit-cost measures Price tren2 s Fnancal ratios Inflaton trends Efficency Protected farm budgets Income Projected enterprise budgets Credsorthiness Balance sheet Break-even and payback period Income statements Benefit-cost ratio Sources-and-uses-of-funds Net present worth statements Internal rate of return Protected government budgets Sensitvity analysis Overall appraisal Review all apects and allp anning Technica aspcis Institutional organizational- management aspects Social aspects Commercial aspects Financial aspects Economic aspects Protect planning Financial and economic Economic pmojections :=eeitcs bnft and costs Bm ection onomic bene fit-cos t measurs F and economic InIltio treds eneft-cst rtioprojections Exchange rate value trends Net present worth Financing plans - Proected farm budgets Internal rate of return Business negotiations Protected enterprise budgets Sensitity analysis Fmancial and economic Protected government budgets Risk assessment benefit-cost measures 40 THE PROJECT CONCEPT we will move on to discuss how these market prices can be transformed into accounts, which become the basis for the financial analysis, first by laying out and projecting model farm budgets (chapter 4). These pro- jected farm budgets form the basis of an idea about how much a farm family participating in a project will have to live on as the project proceeds. This amount with the project, compared with what would be the amount without the project, yields an estimate about the in- cremental income that will accrue to the farm family. On the basis of this estimate, a judgment can be formed about the incentive effect of a proposed project on farmers who might participate. One can also esti- mate the rate of return to the farmer's own capital investment and to all capital invested on the farm. By preparing and projecting budgets for agricultural processing indus- tries such as sugar mills or cotton gins that may be included in a project (chapter 5), one can make similar judgments about the incremental net benefit arising from investment in these firms, whether they are in the public or the private sector, and about the incentives for participation by the private sector if this is to be the vehicle for investment. A separate set of accounts for government agencies (chapter 6) will permit an estimate of the effect of the project on government revenue. With these budgets in hand, the various market prices used in each are adjusted, if need be, to reflect economic values from the standpoint of the society as a whole (chapter 7). These economic values are then totaled or "aggregated," as it is more often termed (chapter 8). This is done for the incremental farm production from the project (either by aggregating according to model types for the total number of farms in the project or by aggregating the total area devoted to the various crops in the project), for all the revenue-earning entities, and for the various government agencies. The aggregation gives the total incremental net benefit the society will realize from the project. From this and from earlier budgets, we can estimate the return that individuals and the society will realize from their investment in the project (chapters 9 and 10). Of course, at each stage in this sequence we will want to review our earlier work and revise it in light of later analysis. The book concludes with a set of generalized guidelines for preparing reports of agricultural and rural development project analyses (appen- dix A), two discounting tables (appendix B), and a brief discussion about institutional sources of assistance for the preparation of agricultural projects (appendix C). An annotated bibliography and a glossary-index are included as references for the reader. , , -� . � �� у �Г' �.� � ` � � � h�t'� ��... � . . �- . � � ,�_Гt АУ 'уΡ 1 7�� ч _ _ 5 �Фo- д� $hiv, � � ! z � � �� , '� R � ' � � . , � л� �( f � ' � � �� с-'L` :� � � , .� , н: s � . � �'� _ �-�� '.� ��'� . ♦ �, д�d�� в�в� ' _� � а • - tь . . - .. мжиrг :� � � ik� г '� 1 �. � _ ' _ � �'�,,. � ��. � - �� i7 ! Г` �Ч , ( `Х � г "в� , , ,- ,. ��5'�.... �� _ �• Ф �� .д(�:,� ti+� � 3 - а h ,'� а r : � � ,. . � �� F. г��с'Ss�U.•.ь�ьf .� �.. \ � � � � , �� .' ио �. в'�� -:...�.�-:Э'д ( - ��i- г� i'�- � �'�' • � s,`�� _ ~ :� _ � _ - ..� ^� ��. ] � � �' _ _ У� '- � � ' . `�� ` :r+� _ . �! sR^�' _ j.. /� r�'� _�`?��"�� '� . '1� t � J?^ _ _ ! a�LV•. �, ,ц 'lT `,:% - �iM� . /}. `_ � �'�+�г - л ' - - -� _ ^-L �' .+� � ,• � �^ .. . � • .� а � -� ' .f 4 �� z-• s�1 г .л.g,� ~�У � \ _ 1 ___ ., � ' .! � _,� ?^^� _� � _ � . .. �,- . ' -� , . .. � . __--. . . ��.� __ _ � � ,_ - ' __ - � . _ , ' . . . ' ..-. - ' 1` � .. _ . 3 Pricing Project costs and Benefits ONCE COSTS AND BENEFITS have been identified, if they are to be compared they must be valued. Since the only practical way to compare differing goods and services directly is to give each a money value, we must find the proper prices for the costs and benefits in our analysis. Prices Reflect Value Underlying all financial and economic analysis is an assumption that prices reflect value--or can be adjusted to do so. In this chapter we will discuss how to find these prices. Before proceeding, however, it is neces- sary to define two economic concepts crucial to project analysis: mar- ginal value product and opportunity cost. Consider a Filipino farmer who applies nitrogenous fertilizer to his rice. In the 1979-80 season this fertilizer cost him F3.98 per kilogram of elemental nitrogen (N), and he received F1.050 for every kilogram of paddy rice he sold. (The symbol for Philippine pesos is F.) Table 3-1 shows the responsiveness of his rice to fertilizer. At low levels of application, fertilizer has a great effect on rice yield. Increasing the application from no fertilizer to 10 kilograms of elemental nitrogen increased the farmer's Facing page: Crossing an irrigation canal in Sudan. 65 66 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 3-1. Crop Response to Nitrogen Fertilizer in the Philippines Paddy rice Shelled maize Marginal Marginal Nitrogena Yield value Yield value (kilograms (kilograms Valueb productc (kilograms Valued product per hectare) per hectare) (P) (P) per hectare) (P) (P) 0 3,442 3,614 29.50 2,600 2,688 23.80 10 3,723 3,909 26 2,830 2,926 1.70 20 3,971 4,170 2210 3,040 3,143 19.70 .60197 30 4,187 4,396 19.20 3,230 3,340 17.60 40 4,370 4,588 15.80 3,400 3,516 15.50 50 4,520 4,746 12 3,550 3,671 13.40 .30134 60 4,637 4,869 880 3,680 3,805 1140 70 4,721 4,957 3,790 3,919 5.40 93 80 4,772 5,011 2 00 3,880 4,012 7.20 90 4,791 5,031 2.10 3,950 4,084 5.20 - 1.50 5.20 100 4,777 5,016 4,000 4,136 3.10 110 4,030 4,167 3.0 1.00 120 4,040 4,177 - 1.00 130 4,030 4,167 P Philippine pesos. Source: Personal communication from Pedro R. Sandoval, University of the Philippines at Los Banos, September 1980. Rice responses are based on Changes in Rice Farming in Selected Areas of Asia (Manila: International Rice Research Institute, 1978), p. 61. Maize responses are based on University of the Philippines at Los Bafilos Experiment Station records. Prices are from the Bureau of Agricultural Economics, Ministry of Agriculture, Republic of the Philippines. a. The farm-gate price of elemental nitrogen (N) in 1979-80 was P3.98 per kilogram. b. The farm-gate price of paddy rice in 1979-80 was F1.050 per kilogram. c. The marginal value product is the extra revenue that comes from increasing the quantity of an input used by one unit, all other quantities remaining constant. In this instance, the marginal value product is the increased value of paddy rice or shelled maize from using I additional kilogram of elemental nitrogen. Note that in this table the interval between levels of elemental nitrogen is 10 kilograms. Thus, the marginal value product of elemental nitrogen applied to rice between the 60- and 70-kilogram levels of application is the difference in value of output between the two levels divided by 10, or V8.80 [(4,957 - 4,869) + 10 = 8.80]. d. The farm-gate price of shelled yellow maize in 1979-80 was F1.034 per kilogram. e. Beyond application of 100 kilograms of elemental nitrogen, all marginal value prod- ucts for paddy rice are negative; therefore, figures for these applications of nitrogen to rice are not reported. yield from 3,442 kilograms to 3,723 kilograms per hectare and increased the value of his output by F295, from F3,614 to F3,909. Thus, for every additional kilogram of elemental nitrogen the farmer applied at this level, he received F29.50 in return [(3,909 - 3,614) - 10 = 29.50]. The extra revenue from increasing the quantity of an input used, all other quantities remaining constant, is the marginal value product of the input. In this case, then, the marginal value product of a kilogram of fertilizer is F29.50. If the farmer could buy fertilizer for F3.98 a kilogram and use it to increase output by P29.50, it obviously would have paid him to apply PRICING PROJECT COSTS AND BENEFITS 67 more. But as the intensity of application increases, each additional kilo- gram of fertilizer has less and less effect on production. If the farmer had increased his application from 80 to 90 kilograms per hectare, he would have increased the value of his production by only F20, from F5,011 to F5,031, and the marginal value product of a kilogram of fertilizer would have fallen to only F2.00 [(5,031 - 5,011) + 10 = 2.00]. Since he would have had to pay F3.98 per kilogram, it clearly would not have been worthwhile to apply fertilizer at this rate. In fact, it would only have paid the farmer to apply fertilizer up to the rate at which the marginal value product just equaled the price. For this Filipino farmer, it would have paid him to apply approximately 80 kilograms of nitrogen: between 70 and 80 kilograms the marginal value product of each additional kilo- gram was some F5.40, whereas between 80 and 90 kilograms it fell to P2.00. Thus, the farmer would have expanded his fertilizer use until he reduced the marginal value product of the fertilizer to its market price, and the market price, therefore, is an estimate of the marginal value product of the fertilizer. The optimal amount of fertilizer to use will change, of course, when the price of fertilizer changes relative to the price of rice. If the relative price of fertilizer were to rise, the farmer would respond by reducing the amount of fertilizer he applies, increasing the marginal value product of the fertilizer (but reducing the total amount and value of production) until the marginal value product of the fertilizer again just equals its price. Suppose fertilizer were to double in price to F8.00 per kilogram of elemental nitrogen, and rice prices remained unchanged. Then, table 3-1 indicates the farmer should reduce the amount of fertilizer applied to a hectare from 80 kilograms to 70 kilograms, since between 60 and 70 kilograms the marginal value product was some P8.80 but between 70 and 80 kilograms it was only some P5.40. In practice, because of risk and limited resources, the farmer would probably not have applied the amounts indicated here. We may consider that the farmer reduces his expected return by some "risk discount." Even so, the principle we are illustrating remains the same: the farmer equates the expected marginal value product less some risk discount to the price of fertilizer. If this farmer also grew maize, for which in 1979-80 he would have received P1.034 per kilogram of shelled grain, table 3-1 indicates it would have paid him (in the absence of risk) to apply some 100 kilograms of elemental nitrogen to each hectare, because between 90 and 100 kilo- grams the marginal value product of a kilogram of nitrogen applied to maize was P5.20, whereas between 100 and 110 kilograms the marginal value product fell to P3.10, below the price of fertilizer. Now, suppose the farmer had limited resources and could not obtain sufficient credit to increase his fertilizer application on both rice and maize to where the marginal value product equaled the price. Suppose the farmer had only 2 hectares, 1 planted in rice and 1 in maize, and resources sufficient to purchase just 80 kilograms of nitrogen. How should he have used it? Should he have put it all on rice and none on 68 FINANCIAL ASPECTS OF PROJECT ANALYSIS maize? If he did, he would have applied fertilizer to his rice at the level where the marginal value product was just about equal to its market price. But suppose he had shifted some fertilizer, instead, to maize. If he had shifted 10 kilograms, he would have reduced the value of his rice production by V54-from F5,01 1 to F4,957, or by F5.40 for each kilogram shifted-but he could have obtained some P238 for the 10 kilograms applied to maize, since the marginal value product between 0 and 10 kilograms was some P23.80 per kilogram. In other words, at these levels each kilogram of nitrogen shifted would reduce the rice value by F5.40 but increase the value of maize output by some F23.80. In the language of economics, the opportunity cost of fertilizer shifted from rice to maize was P5.40. Opportunity cost, thus, is the benefit forgone by using a scarce resource for one purpose-in this case applying fertilizer to maize- instead of for its best alternative use-in this case using the fertilizer to produce rice. Said another way, the opportunity cost is the return a resource can bring in its next best alternative use. What would be the opportunity cost if the farmer were to move a kilogram of fertilizer in the other direction, back from maize to rice? He would have given up P23.80 to gain only P5.40-not a very attractive proposition-and the opportu- nity cost, obviously, would be some P23.80. Given his limited resources, it would pay the farmer to shift fertilizer from rice to maize until the marginal value product of fertilizer applied to both crops is the same. In the case of the Filipino farmer who could buy only 80 kilograms of fertilizer, if on the one hand he were to move 40 kilograms to maize, reducing his application on rice from 80 kilograms to 40 kilograms, he would have increased the marginal value product of the fertilizer on his rice to some P15. On the other hand, the 40 kilograms shifted away from rice and put on maize would have decreased the marginal value product of nitrogen applied to maize also to about P15. At these levels, there would be no advantage in shifting fertilizer between the two crops-the opportunity cost of shifting more fertilizer from rice to maize would be about P15, but the gain would also be only about P15-and the farmer would have reached the optimal level of application to both crops. Note, however, that if the farmer could somehow have bought as much fertilizer as he wanted at the market price of P3.98 per kilogram- perhaps through a credit program-then the market price of fertilizer would have become its opportunity cost, and (in the absence of a risk discount) he should have increased his application to 80 kilograms on rice and 100 kilograms on maize. From a single farmer to the economy as a whole, the same principles apply. In a "perfect" market-one that is highly competitive, with many buyers and sellers, all of whom have perfect knowledge about the mar- ket-every economic commodity would be priced at its marginal value product, since every farmer will have expanded his fertilizer use to where its marginal value product equals its price, and the same will have happened for every other item in the economy. That is, the price of every good and service would exactly equal the value that the last unit utilized PRICING PROJECT COSTS AND BENEFITS 69 contributes to production, or the value in use of the item for consumption would exactly balance the value it could contribute to additional produc- tion. If a unit of goods or services could produce more or bring greater satisfaction in some activity other than its present use, someone would have been willing to bid up its price, and it would have been attracted to the new use. When this price system is in "equilibrium," the marginal value product, the opportunity cost, and the price will all be equal. Resources will then have been allocated through the price mechanism so that the last unit of every good and service in the economy is in its most productive use or best consumption use. No transfer of resources could result in greater output or more satisfaction. Without moving further into price theory, we can consider some direct implications for agricultural projects of the assumption that prices reflect value. First, as everyone knows, markets are not perfect and are never in complete equilibrium. Hence, prices may reflect values only imperfectly. Even so, there is a great deal of truth in this price theory based on the model of perfect markets. In general, the best approximation of the "true value" of a good or service that is fairly widely bought and sold is its market price. Somebody in the economy is willing to pay this price. One can presume that this buyer will use the item to increase output by at least as much as its price, or that he is willing to exchange something of value equal to the price to gain the satisfaction of consuming the item. Hence, the market price of an item is normally the best estimate of its marginal value product and of its opportunity cost, and most often it will be the best price to use in valuing either a cost or a benefit. In financial analysis, as we have noted, the market price is always used. But in economic analysis some other price-a "shadow price"-may be a better indicator of the value of a good or service; that is, a better estimate of its true opportunity cost to the economy. When prices other than market prices are used in economic analysis, however, the burden of proof is on the analyst. Finding Market Prices Project analyses characteristically are built first by identifying the technical inputs and outputs for a proposed investment, then by valuing the inputs and outputs at market prices to construct the financial accounts, and finally by adjusting the financial prices so they better reflect economic values. Thus, the first step in valuing costs and benefits is finding the market prices for the inputs and outputs, often a difficult task for the economist. To find prices, the analyst must go into the market. He must inquire about actual prices in recent transactions and consult many sources- farmers, small merchants, importers and exporters, extension officers, technical service personnel, government market specialists and statisti- cians, and published or privately held statistics about prices for both 70 FINANCIAL ASPECTS OF PROJECT ANALYSIS national and international markets. From these sources the analyst must come up with a figure that adequately reflects the going price for each input or output in the project. Point of first sale and farm-gate price In project analysis, a good rule for determining a market price for agricultural commodities produced in the project is to seek the price at the "point of first sale." If the point of first sale is in a relatively competi- tive market, then the price at which the commodity is sold in this market is probably a relatively good estimate of its value in economic as well as financial terms. If the market is not reasonably competitive, in economic analysis the financial price may have to be adjusted better to reflect the opportunity cost or value in use of the commodity. For many agricultural projects in which the objective is increased production of a commodity, the best point of first sale to use is generally the boundary of the farm. We are after what the farmer receives when he sells his product-the "farm-gate" price. The increased value added of the product as it is processed and delivered to a market arises as a payment for marketing services. This value added is not properly attrib- uted to the investment to produce the commodity. Rather, it arises from the labor and capital engaged in the marketing service. Usually the price at point of first sale can be accepted as the farm-gate price; even if this point is in a nearby village market, the farmer sells his output there and thus earns for himself any fee that might be involved in transporting the commodity from the farm to the point of first sale. But if any new equipment is necessary to enable the farmer to do this-say, a new bullock cart or a new truck-then that new equipment must be shown as a cost incurred to realize the marketing benefit in the project. In projects producing commodities for well-organized markets, the farm-gate price may not be too difficult to determine. This would be true for most food grains traded domestically in substantial quantities. One may think of wheat in most countries of the Middle East and South Asia, of rice in South and Southeast Asia, and of maize in much of Latin America. It would also be true of farm products for which the processor is generally the first buyer (such as fresh fruit bunches for palm oil in Malaysia or milk in Jamaica), where the price quoted to the farmer is the price on his farm, and the firm responsible for the marketing comes to the farm to pick up the product. In many cases, however, the prices in a reasonably competitive market or in the price records kept by the government statistical service will include services not properly attributable to the investment in the proj- ect itself. This may happen, for instance, when the only price series available for a product records the prices at which it has been sold in a central market-such as the price for eggs in Madras, for melons in Tehran, or for vegetables in Bogota. In that case, the project analyst will have to dig deeper to find out how to value the marketing services. Then he can adjust the central market price to reduce it to the farm-gate price. PRICING PROJECT COSTS AND BENEFITS 71 The farm-gate price is generally the best price at which to value home-consumed production. In some cases it may be extremely difficult to determine just what a realistic farm-gate price is for a crop produced primarily for home consumption because so little of the crop appears on markets. This is the case, for example, for manioc and cocoyam in Africa. On the one hand, some argue that the true value of the crop is overstated if the market price is used as a basis for valuation because such a small proportion of the product is actually sold. On the other hand, the same crop in different situations may not be so difficult to value. Manioc is sold extensively in Nigeria to make gari flour, and it is commonly traded in local markets in tropical Latin America and the Caribbean. The farm-gate price may be a poor indicator of the true opportunity cost we want to use in economic analysis. In Ghana the Marketing Board takes some proportion of the cocoa price as a tax for development pur- poses. In Thailand, a rice "premium"-that is, a tax on rice exports- effectively keeps the domestic price well below what the international market would pay. In these cases, when the commodity is traded its economic value would have to be considered higher than the actual farm-gate price, and this price distortion will have to be corrected in the economic analysis. In other cases, just the opposite happens. In Mexico the price of maize is maintained at a high level to transfer income to ejidatarios, the small farmers. In Malaysia, the price of rice is supported above world market levels to encourage local production and to reduce imports. In these cases, part of the price does not really reflect the economic value of the product-its cost if it could be imported-but rather an indirect income transfer to small farmers. Again, this price distortion will have to be corrected in the economic analysis. Pricing intermediate goods By emphasizing the point of first sale as a starting point for valuing the output of our projects, we are also implying that imputed prices should be avoided for intermediate goods in our analysis. An intermediate good is an item produced primarily as an input in the production of another good. If an intermediate good is not freely traded in a competitive mar- ket, we cannot expect to obtain a price established by a range of competi- tive transactions. Fodder produced on a farm and then fed to the dairy animals on the farm is an example of such an intermediate product. If increased fodder production is an element in the proposed agricultural project, the analyst would avoid valuing it. Instead, the analyst would treat the whole farm as a unit and value the milk produced at its point of first sale or value the calves sold as feeder cattle. Treatment of intermedi- ate products will vary from project to project depending on the particu- lar marketing structures. In some countries it would hardly make sense in an egg production project to value the pullets produced in a pullet production enterprise and then "sell" these pullets to the egg production enterprise on the same farm. But in other countries there might be an active market in pullets, which would mean that we could expect to find a 72 FINANCIAL ASPECTS OF PROJECT ANALYSIS reasonably competitive price to use in the economic analysis. To avoid most of the problems that might be introduced by trying to impute values for intermediate products, the financial accounts in agricultural projects are based on budgets for the whole farm instead of on budgets for individual activities on the farm; that is, on the budget for the egg farm as a whole rather than on the budget for a pullet production activity. A frequently encountered intermediate good in agricultural projects is irrigation water. The "product" of an irrigation system-water-is, of course, really intended to produce agricultural commodities. The price farmers are charged for the water is generally determined administra- tively, not by any play of competitive market forces. If the analyst were to try to separate the irrigation system from the production it makes possi- ble, he would be faced with a nearly impossible task of determining the value of irrigation water. Hence, it is not surprising that the economic analyses of most irrigation projects take as the basis for the benefit stream the value of the agricultural products that are offered in a rel- atively free market at the point of first sale. Other problems in finding market prices Considerable confusion often arises in determining the values for two important inputs in agricultural projects, land and labor. This happens primarily when the analysis moves from the financial project accounts to the economic analysis (to which we will turn in chapter 7). In the accounts prepared for the financial analysis, the treatment of prices for land and labor is quite straightforward: the price used is the price actually paid. Thus, if the farmers in a settlement project are expected to pay the project authority a price for the land they acquire, perhaps through a series of installments, then the actual price in the year it is paid is entered in the project accounts. In the financial analysis, we do not question whether this is a "good" price in economic terms. Similarly, if land must be bought for the right-of-way for canals in an irrigation project, the actual price to be paid is entered in the project accounts in the financial analysis. Or, if the project includes tenant farmers who will receive help in increasing wheat production, then in the financial accounts for these tenant farmers the analyst will enter the rent paid each year at the amount actually paid, or at the farm-gate value of the wheat delivered to the landowner if the tenants pay rent in kind. If farm accounts are laid out on a with-and-without basis following the format suggested in chapter 4, in those instances where the project involves only changing the cropping pattern (say, a shift from pasture to irrigated sorghum), the cost of the land (in this instance an opportunity cost) need not be separately entered because of the form of the account. When the net benefit without the project is subtracted from the net benefit with the project, the contribution of the land to the old cropping pattern is also subtracted and only the incremental value remains. In valuing labor for the financial analysis accounts, again, the prob- lems arise when the financial accounts are adjusted to reflect economic PRICING PROJECT COSTS AND BENEFITS 73 values. For financial analysis, the analyst enters the amounts actually paid to hired labor, either in wages or in kind, in the farm budgets or project accounts. Family labor is treated differently. It is not entered as a cost; instead, the "wages" for the family become a part of the net benefit. Thus, if our project increases the net benefit, it also in effect increases the family's income or "wages" for its labor. Again, if we follow the format suggested in chapter 4, the account will automatically value the family labor at its opportunity cost, and the incremental net benefit will reflect any increased return the family may receive for its labor. Prices for agricultural commodities generally are subject to substan- tial seasonal fluctuation. If this is the case, some decision must be made about the point in the seasonal cycle at which to choose the price to be used for the analysis. A good starting point is the farm-gate price at the peak of the harvest season. This is probably close to the lowest price in the cycle. The line of reasoning here is that as prices rise during the cycle at least some part of that rise is a result not of the production activities of the farmer but of the marketing services embodied in storing the crop until consumers want it. But, markets being what they are, there may be an element of imperfection in the harvest price level. Market channels may become so glutted that merchants try actively to discourage farmers from immediately bringing their crop to the market by offering a price that even the merchants themselves would admit is too low. Even so, the need to sell immediately to meet debt obligations may force farmers to offer their crops despite these artificially low, penalty prices. In some cases, therefore, a price higher than the farm-gate price in the harvest season may be selected. But there is an obligation here to justify the price chosen as more valid than the lowest seasonal price. One way to resolve this problem may be to include an element of credit in the project design. This would permit farmers to withhold their product from the market until prices have had a chance to rise from their seasonal lows but at the same time to have enough money to meet their cash obligations and family living expenses. The credit element may also include credit for building on-farm storage so that farmers will have a safe place to store their production until they decide to market it at a better price. Prices vary among grades of product, of course, and picking the proper price for project analysis may involve making some decisions about quality of the product. In general, it can be assumed that farmers will produce in the future much the same quality as they have in the past and will market their product ungraded. In many agricultural projects, however, one objective is to upgrade the quality of production as well as to increase the total output. Small dairy farmers, for instance, may be able with the help of the project investment to meet the sanitation standards of the fluid milk market and to command a higher price; or reduced time for delivery may hold down sucrose inversion in sugarcane; or better pruning will increase the average size of the oranges Moroccan farmers can offer European buyers. In such cases, the proper price to select is the average price expected for the quality to be produced. A special problem occurs in pricing housing. If project investment 74 FINANCIAL ASPECTS OF PROJECT ANALYSIS includes housing construction, as would be the case for a settlement project, then one benefit arising from the investment is the rental value of the house. Since the rental value will usually be an imputed value rather than a real market price, care must be exercised in determining it. No more should be allowed for the rental value than would normally be paid by a prospective tenant family. Nor should more rental value be allowed than the family would be expected to pay for a comparable house in the vicinity or in a similar area elsewhere (if the new settlement is in a distant locale). In particular, the temptation should be avoided to take as a rental value some arbitrary proportion of the housing cost. Otherwise, overly elaborated housing construction might be justified simply by assigning it an unrealistically high imputed value. Project boundary price Prices used in analyzing agricultural projects are not necessarily farm- gate prices. The concept of a farm-gate price may be expanded to a "project boundary" price if a project has a marketing component or if it is a purely marketing project. Many projects have a marketing compo- nent, perhaps because there is no competitive channel reaching down to the farm-gate level for the unprocessed product. Of concern in these projects are both the farm-gate price (on which to base the estimates of the net benefit to the farmer) and the price at which the processed product is sold in the market (after being handled in the facilities financed by the project). Such a case is found in the Rahad project in the Sudan. There the Roseires dam on the Blue Nile will provide irrigation water for the production of cotton, which will be ginned in new facilities financed by the project. The analyst, of course, is interested in the price of cotton paid to the farmers so that their incomes can be estimated. But, since this price is set administratively, it could not be used directly in the economic analysis of the project. The analyst is also interested in the price of ginned cotton because that is the first product the project will actually sell in a reasonably competitive market. In this case, the point of first sale is f.o.b. (free on board) Port Sudan, and the price there becomes the basis for the benefit stream. Predicting Future Prices Since project analysis is about judging future returns from future investment, as analysts we are immediately involved in judging just what future prices may be. This is a matter of judgment, not mechanics. No esoteric mathematical model exists to come to the aid of the project analyst; like everyone else he must take into consideration all the facts he can find, seek judgments from those he respects, and then come to a conclusion himself. It tends to be a rather unsettling process. The only consolation is that careful, considered judgment about the course of PRICING PROJECT COSTS AND BENEFITS 75 future prices is better than giving the matter no thought at all and wasting scarce resources on incompletely planned projects. We have been discussing how to find market prices, and it is from these current prices that we begin. The best initial guess about future prices is that they will retain the present relationships, or perhaps the average relationship they have borne to each other over the past few years. We must consider, however, whether these average relationships will change in the future and how we will deal with a general increase in the level of prices owing to inflation. Changes in relative prices We may first raise the question of whether relative prices will change. Will some inputs become more expensive over time in relation to other commodities? Will some prices fall relatively as supplies become more plentiful? Not easy questions to deal with, but some approaches to answers can be made. In financial analysis, of course, a change in a relative price means a change in the market price structure that produc- ers face either for inputs or for outputs. A change in a relative price, then, is reflected directly in the project's financial accounts. A rise in the relative price of fertilizer reduces the incremental net benefit-the amount the farm family has to live on. It is thus clearly a cost in the farm account. The same line of reasoning can be applied in the financial analysis for any other group participating in the project. A change in the relative price of an item implies a change in its marginal productivity-that is, a change in its marginal value product- or a change in the satisfaction it contributes when it is consumed. In economic analysis, where maximizing national income is the objective, a change in the relative price of an input implies a change in the amount that must be forgone by using the item in the project instead of elsewhere in the economy; it is therefore a change in the contribution the output of the project makes to the national income. Thus, changes in relative prices have a real effect on the project objective and must be reflected in project accounts in the years when such changes are expected. There are several kinds of commodities subject to future changes in relative prices. Most agricultural project analysts would probably agree that the relative price of energy-intensive agricultural inputs is likely to continue to rise over the next several years, just as it has done over the past few years. Thus, on the input side the project accounts might show an annual increase, at least for the first decade or so, in the cost of fuel for tractors, for transporting the harvested crop, for drying grain, and for such petroleum-based inputs as fertilizers and chemical pesticides. On the output side, there may be some commodities that will probably continue to be in short supply and whose prices will rise as incomes increase-one might think of mutton from fat-tailed sheep in Iran, or, for that matter, of most meat products worldwide. How much will prices increase relative to those of other products? Certainly a difficult ques- 76 FINANCIAL ASPECTS OF PROJECT ANALYSIS tion, but one the project analyst must confront. For a range of products- from industrial crops such as fibers or oilseeds to food grains and vege- tables-judgments will have to be made on the best possible basis. In some countries, relative wages of rural labor may rise as economic development proceeds during the life of a project. This will have implica- tions not only for the prices assumed for hired labor, but also for the incentive effect exerted by a given change in net benefit and for the technology assumed as a basis for projections in the farm budgets and project accounts. Inflation In the past few years, virtually every country has experienced inflation, and the only realistic assessment is that this will continue. No project analyst can escape deciding how to deal with inflation in his analysis. The approach most often taken is to work the project analysis in constant prices. That is, the analyst assumes that the current price level (or some future price level-say, for the first year of project implementa- tion) will continue to apply. It is assumed that inflation will affect most prices to the same extent so that prices retain their same general rela- tions. The analyst then need only adjust future price estimates for antici- pated relative changes, not for any change in the general price level. By comparing these estimates of costs and benefits with the constant prices, he is able to judge the effects of the project on the incomes of participants and its income-generating potential for the society as a whole. Although the absolute (or money) values of the costs and benefits in both the financial and the economic analyses will be incorrect, the general rela- tions will remain valid, and so the measures of project worth discussed in chapter 9 may be applied directly. Working in constant prices is simpler and involves less calculation than working in current prices; for the latter, every entry has to be adjusted for anticipated changes in the general price level. It is quite possible, however, to work the whole project analysis in current prices. This has the advantage that all costs and benefits shown would be estimates of what the real prices will be in each year of the project. Furthermore, estimates of investment costs will be in current terms for the year in which they are expected to occur, so that the finance ministry can more easily anticipate these needs and budget the amounts necessary to finance the project on schedule. The problem in this approach is that it involves predicting inflation rates. For items to be imported, some help is available in the World Bank report on Price Prospects for Major Primary Commodities (1982a), which is published biennially and updated in six-month intervals and includes an estimate of inflation in developed countries. For domestic inflation rates in de- veloping countries, other sources will have to be consulted, but obtaining an estimate in which one can place even minimal confidence will be difficult, to say the least. Even casting the project analysis in current terms may raise problems for the project analyst. Many governments PRICING PROJECT COSTS AND BENEFITS 77 have policy goals that call for greatly reduced inflation, and they cannot permit the circulation of official documents that assume rapid inflation will continue. The mere mechanics of using current prices presents no analytical problem in project analysis, although it does complicate the computa- tions. When we consider measures of project worth, some means of deflating future prices must be adopted for comparing future cost and benefit streams in terms that are free from the effects of general price increases. We will illustrate the methodology in chapter 10 in the section "Calculating Measures of Project Worth Using Current Prices." Even when constant prices are used in the more conventional approach to project analysis, a table estimating the budgetary effects of the project in current terms that will prevail at least during the invest- ment phase should be included either in the analysis or as a separate memorandum. It would list in current prices domestic currency needs, foreign exchange requirements, and subsidies. The finance ministry would then have better estimates to work with, and delays because of budgetary shortfalls could more easily be avoided. Prices for Internationally Traded Commodities For commodities that enter significantly in international trade, whether inputs or outputs, project analysts usually obtain price informa- tion from various groups of specialists who follow price trends and make projections about relative prices in the future. In many countries where agricultural exports are important, there are groups in the agriculture ministry or the finance ministry whose help may be sought. There are also several international organizations and trade groups to which the analyst may turn. The World Bank, for instance, publishes its projections under the title Price Prospects for Major Primary Commodities. The Food and Agriculture Organization (FAO) sponsors intergovernmen- tal groups that publish price information on rice; grains (other than rice); citrus; hard fibers; fibers (other than hard fibers); oilseeds, oils and fats; bananas; wine and wine products; tea; meat; and cocoa. Information may be obtained from the secretary of the relevant intergovernmental group at the FAO headquarters in Rome or from the FAO representative in individual countries. Several international commodity organizations keep detailed price information for the products of their interest. These include the Interna- tional Tea Committee, the International Cocoa Organization, the Inter- national Wool Secretariat, the International Coffee Organization, the International Association of Seed Crushers, the International Rubber Study Group, and the International Sugar Organization, all with head- quarters in London; the International Olive Oil Council in Madrid; and the International Cotton Advisory Committee in Washington. Some individual nations systematically collect production and price information for crops and livestock products of interest to them, and they 78 FINANCIAL ASPECTS OF PROJECT ANALYSIS often are willing to share this information with analysts in other coun- tries without charge or restriction. The United States Department of Agriculture-probably the most important of these-publishes detailed studies about most major crops traded in international markets. In- formation may be obtained from agricultural attaches in American embassies, or directly from the department's Foreign Agriculture Ser- vice. The Commonwealth Secretariat in London publishes information about price trends for commodities of interest to its member nations. A detailed list of "Sources of Information on World Prices" is available from the World Bank (Woo 1982). Financial Export and Import Parity Prices In projects that produce a commodity significant in international trade, the price estimates are often based on projections of prices at some distant foreign point. The analyst must then calculate the appropriate price to use in the project accounts, either at the farm gate or at the project boundary. If the farm-gate or project boundary prices for the internationally traded commodities in the project are already known, and the prices in the particular country tend to follow world market prices, the farm-gate prices may be adjusted by the same relative amount as indicated, say, by the medium trend projected in the future relative prices supplied by one or another international organization. Also, in financial analysis, if the farm-gate price is set administratively and is not allowed to adjust freely to world prices, the relevant price to use is the administratively set price. Simply adjusting domestic prices by the same relative amount as foreign prices often arrives at figures too rough for project analysis. The approach ignores the fact that marketing margins in commodity trade tend to be less flexible than the commodity prices themselves. There are also many instances in estimating the economic value of a traded com- modity that involve deriving a shadow price based on international prices. In such instances it is necessary to calculate export or import parity prices. (See chapter 7, the subsection "Economic export and im- port parity values.") These are the estimated prices at the farm gate or project boundary, which are derived by adjusting the c.i.f. (cost, insur- ance, and freight) or f.o.b. prices by all the relevant charges between the farm gate and the project boundary and the point where the c.i.f. or f.o.b. price is quoted. The elements commonly included in c.i.f. and f.o.b. are given in table 3-2. One common case for which an export parity price has to be calculated is that of a commodity produced for a foreign market. Table 3-3 gives an example based on the Rahad project in the Sudan. It shows the general- ized elements for calculating export parity prices so that the same methodology can be applied in other cases. As noted earlier, the Rahad project included cotton gins. Since the gins produce lint and cottonseed for export and scarto, a by-product of very short fibers not suitable for PRICING PROJECT COSTS AND BENEFITS 79 Table 3-2. Elements of C.i.f (Cost, Insurance, Freight) and F.o.b. (Free on Board) Item Element C.i.f. Includes: F.o.b. cost at point of export Freight charges to point of import Insurance charges Unloading from ship to pier at port Excludes: Import duties and subsidies Port charges at port of entry for taxes, handling, storage, agents' fees, and the like F.o.b. Includes: All costs to get goods on board-but still in harbor of exporting country: Local marketing and transport costs Local port charges including taxes, storage, loading, fumigation, agents' fees, and the like Export taxes and subsidies Project boundary price Farm-gate price Source: William A. Ward, "Calculating Import and Export Parity Prices," training mate- rial of the Economic Development Institute, CN-3 (Washington, D.C.: World Bank, 1977), p. 8. export and sold locally, the analyst needed three prices. For the lint and seed estimates, he began with forecasts of the 1980 c.i.f. prices in current terms at Liverpool, which were available from World Bank publications. From these c.i.f. prices, he then deQucted insurance, ocean freight, export duties, port handling costs, and rail freight from the cotton gin at the project site to Port Sudan, thus obtaining the export parity prices at the project boundary: £Sd178.650 for lint and £Sdl8.097 for seed. (The symbol for Sudanese pounds is £Sd.) The price for scarto, which was not exported, was based on the prevailing domestic price. To illustrate, we may continue to calculate the export parity price at the farm gate, although in the Rahad example, where the farm-gate price was set administratively, this calculation was not made. The computa- tions are laid out in the part of table 3-3 that continues from the entry for "Equals export parity price at project boundary." Here a new issue arises. The three products that the gin produces-lint, seed, and scarto- must be converted into their seed cotton equivalents, since it is seed cotton that the farmer sells. Similar conversions have to be made in many other instances-for example, rice milling or groundnut decortica- tion. For the Rahad project, a weighted price of £Sd83.239 for the seed cotton was calculated using a ginning outturn of 40 percent lint, 59 percent seed, and 1 percent scarto. From this weighted price were de- ducted the ginning, baling, and storage charges and the costs of collec- 80 FINANCIAL ASPECTS OF PROJECT ANALYSIS tion and transport from the farm gate to the gin, thus arriving at the farm-gate export parity price of £Sd66.946. A parallel computation leads to the import parity price. Here the issue is the price at which an import substitute can be sold domestically if it must compete with imports. Table 3-4 illustrates this issue with the example of maize production in Nigeria. The same example is presented diagrammatically in figure 3-1. Nigeria is a net maize importer, and the project is to produce maize for domestic consumption to replace im- ported maize. We begin with the f.o.b. price at the point of export-in this case U.S. ports on the Gulf of Mexico-derived from World Bank com- modity estimates. To this we add freight and insurance to obtain the c.i.f. price at either Lagos or Apapa, the two Nigerian ports concerned. Then we would add any tariffs and subsidies (in this case there are none); add Table 3-3. Financial Export Parity Price for Cotton, Rahad Irrigation Project, Sudan (1980 forecast prices) Relevant step Value per ton Step in the in the calculation Sudanese example Lint Seed Scartoa C.i.f. at point of import C.i.f. Liverpool (taken as estimate for all European ports) US$639 33 US$103.39 - Deduct unloading at point of import Freight and Deuc mrih oisurance - 39.63 - 24.73 - point of import Deduct insurance Equals f.o.b. at point of export F.o.b. Port Sudan US$599.70 US$78.66 - Convert foreign currency Converted at official to domestic currency exchange rate of at official exchange £Sdl.000 = US$2.872 £Sd208.809 £Sd27.389 - rate Deduct tariffs Export duties - 17.813 - 1.000 - Add subsidies (None) Deduct local port Port handling cost charges Lint: £Sd5.564 per ton - 5.564 - Seed: £Sdl.510 per ton - 1.510 Deduct local transport Freight to Port Sudan and marketing costs at £Sd6.782 from project to per ton - 6.782 6.782 - point of export (if not part of project cost) Equals export parity Export parity price price at project at gin at project boundary site fSd178.650 £Sdl8.097 - PRICING PROJECT COSTS AND BENEFITS 81 Table 3-3 (continued) Relevant step Value per ton Step in the in the calculation Sudanese example Lint Seed Scartoa Conversion allowance Convert to seed cotton if necessary (£Sd178.650 x 0.4 + £Sdl8.097 x 0.59 + Sd110.200 x 0.01)b 71.460 10.677 1.102 £Sd83.239 Deduct local storage, Ginning, baling, transport, and and storage marketing costs (£Sdl5.229 per (if not part ton) - 15.229 of project cost) Collection and internal transfer (£Sd 1.064 per ton) - 1.064 Equals export parity Export parity price price at farm gate at farm gate £Sd66.946 £Sd Sudanese pounds. US$ U.S. dollars. Source: Adapted from World Bank, "Appraisal of the Rahad Irrigation Project," PA-139b (Washington, D.C., 1973; restricted circulation), annex 16, table 6. The format of the table is adapted from Ward, "Calculating Import and Export Parity Prices," p. 9. a. Scarto is a by-product of very short, soiled fibers not suitable for export and is sold locally at a price of £Sdl 10.200 per ton. b. Seed cotton is converted into lint, seed, and scarto assuming 1 ton of seed cotton yields 400 kilograms lint, 590 kilograms seed, and 10 kilograms scarto. local port charges for harbor dues, fumigation, handling, and the like; and add local transport to the relevant inland market. The result is the wholesale price of imported maize. It is this wholesale price of maize in the inland market that is the focal point, of our calculation. The alterna- tive to project production is not to import the maize and transport it to the project area. Rather, the alternative is to import it and market it directly on the inland market. Thus the price the farmer can expect to receive in the absence of tariffs, subsidies, or an import ban is the wholesale price less the cost of moving his maize to the market. If the project had included processing facilities, then the relevant project boundary price would have been this wholesale price less handling costs from the processing facility to the wholesale market. In the Nigerian project, no processing facilities were included, so the relevant import parity price is the farm-gate price. As we move back from the wholesale market to the farm gate, we would have to provide for any conversion allowance. In this case none is necessary, since it is assumed that the farmer will sell shelled maize. From the wholesale price, then, we deduct local marketing costs including assembly, bags, and intermediary mar- 82 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 3-4. Financial Import Parity Price of Early-crop Maize, Central Agricultural Development Projects, Nigeria (1985 forecast prices in 1976 constant terms) Value Relevant steps in per Steps in the calculation the Nigerian example ton F.o.b. at point of export F.o b. U.S. Gulf ports No.2 U.S. yellow corn in bulka US$116 Add freight to point of import Freight and insurance 31 Add unloading at point of import (Included in freight estimate) Add insurance Equals c.i.f. at point of import C.i.f. Lagos or Apapa US$147 Convert foreign currency Converted at official to domestic currency at exchange rate of official exchange rate NI = US$1.62 N91 Add tariffs (None) Deduct subsidies (None) Add local port charges Landing and port charges (including cost of bags) 22 Add local transport Transport (based on a and marketing costs 350-kilometer average) 18 to relevant market Equals price at market Wholesale price N 131 Conversion allowance if necessary (Not necessary) Deduct transport Primary marketing (includes and marketing costs assembly, cost of bags, to relevant market and intermediary margins) - 14 Transport (based on a 350-kilometer average) - 18 Deduct local storage, transport, and marketing costs (if Storage loss (10 percent not part of project cost) of harvested weight) - 9 Equals import parity price Import parity price at farm gate at farm gate N90 N Nigerian naira. Source: Adapted from World Bank, "Supplementary Annexes to Central Agricultural Development Projects," 1370-UNI (Washington, D.C., 1976; restricted circulation), supple- ment 11, appendix 2, table 4. The format of the table is adapted from Ward, "Calculating Import and Export Parity Prices," p. 10. a. Forecast from World Bank, Price Prospects for Major Primary Commodities, 814/76 (Washington, D.C., 1976), annex 1, p 12. gins, transport from the farm to the market, and storage losses, thus obtaining the import parity price at the farm gate of N90. (The symbol for Nigerian naira is N.) This is the maximum price the farmer could expect to receive, again in the absence of tariffs, subsidies, or an import ban. PRICING PROJECT COSTS AND BENEFITS 83 Figure 3-1. Diagrammatic Derivation of Import Parity Price of Early-crop Maize, Central Agricultural Development Projects, Nigeria (1985 forecast prices in 1976 constant terms) WHOLESALE PRICE AT INLAND MARKET N 131 Transport to inland market + N18 Local port charges +N22 - N14 Primary marketing (Price converted at official exchange rate of N = US$1.62) -N 18 Transport from project C.I.F. N91 to market LAGOS OR APAPA US$147 Freight - N9 Storage loss and + US$31 insurance F.o.B. US$116 IMPORT PARITY PRICE U.S. GULF PORTS S90 AT FARM GATE N Nigerian naira. US$ U.S. dollars. Source: Same as table 3-4. �` це'.�Zy т;,у µ. �� у .� 7 в' .,r�, `�� ... i у�Ъt�';�� , � �.' •� . �� - . ' дл` � . . 'L'�� • � ' `е"д�t' Tr:. ** е ' w . � �'г � ��' � �,��z'. п � ��" �У. �� _.�';��4� К� i � 1 _�� F w' : в5 . �-�" '� � . �•"° "� � � _ � ь„ ,I, _ • _ � � � 1 =_ � '�r ,�� - ,Ъ"�Т у- .�-•.У J � . �лФ�и К - `�i� � � . � �� .�.,8�,�, `� � � �и� й',У « -�'�rt д' _-- �f '" �i��( ' ��..� -� в.г • _ �..� � Э � r. � �"� �• � � � ! '� " � � ;,� � �� . . � �„ `� � . � � R� � ` M1-*� ` �..� � !�, .. � � � • � �. '�' • ! ' ' �,i.1 � � ��:�.-- а`�. •� ъ�� 1 � � ,� ` � �'s г# 4'>, • � а �� _ �� .J ` � � �л. . � У р � i Ч.; � �i� _! � �i � ` � � ч -эt: ,�,�г �"' э.. ' � ._'_ ,._-- � � `� ;. �� ` �� :и f, ,. ° � - �� и , , �:.. ' 1 • . . .г� , � .�,� 'r ��_ fi �у' � • � � , � �. �� '..._� `ё 11/'� - +i� . `�� . -'h:�' �Г�,., �'- � ��_, tVCy�� ,.��_О ` � �,.У �±, � . ,} . �.��.. ��,�r4°�' G "# �'т р� ' _�_ •.� ,� -� �у,�г +.у-i��,v�*'�''.II.� � ; �"�'�.'�� г' - _. �4.:. �sг-<;'�`�.иg't�"' т`s.._`'¢� ' '"•, �� '� .. . �. 4 Farm Investment Analysis ONCE MARKET PRICES have been determined for those items that enter the cost and benefit streams, this information must be arranged in "pattern" accounts to begin the assessment of the effects a proposed project will have on the farmers, public and private enterprises, and government agencies that will participate in project implementation. These accounts are central to the financial analysis of agricultural projects; they are always based on market prices. Although we will touch on the essential elements of financial analysis, much more could be taken up here. Just how elaborate the financial analysis must be for a particular project will depend on the complexity of the project. Most agricultural projects will call for a financial projection based on at least one pattern farm plan that is assumed for participating farmers. This pattern (or model) farm plan projects resource use and income flows for a group of similar farms participating in the project. The financial projections for the private and public firms or project entities may be quite summary in nature for a simply organized project, but a project in which several different firms and project entities are concerned or one that poses special financial problems may involve a much more complex analysis. The major accounts needed will be out- lined in this chapter and in chapters 5 and 6, and pattern formats Facing page: Setting out for the field in Paraguay. 85 86 FINANCIAL ASPECTS OF PROJECT ANALYSIS suggested. This will enable the project analyst to proceed with the con- fidence that he is preparing an acceptable financial analysis. For more complex projects, especially those projects involving more complex pub- lic or private firms with specialized cost, revenue, or financing situations, the project analyst will have to move beyond what is discussed here. Agricultural project analysts may want to turn for more technical help to financial analysts or accountants, just as they would turn to agricultural- ists or livestock technicians for their particular expertise. Many financial analysts and accountants, however, will not be familiar with methodolo- gies of agricultural project analysis or with the particular analytical needs of the financial aspects of these projects, so even financial analysts and accountants may find that the following discussion may help them respond to a request for assistance. Objectives of Financial Analysis Six major objectives for financial analysis occur in analyzing agri- cultural projects. Assessment of financial impact The most important objective of financial analysis is to assess the financial effects the project will have on farmers, public and private firms, government operating agencies, and any others who may be par- ticipating in it. This assessment is based on an analysis of each partici- pant's current financial status and on a projection of his future financial performance as the project is implemented. Detailed financial projec- tions are needed for this analysis. Judgment of efficient resource use The overall return of the project and the repayment of loans extended to individual enterprises are important indicators of the efficiency of resource use. For management especially, overall return is important because managers must work within the market price framework they face. Farm investment analysis and financial ratio analysis provide the tools for this review. Project analysts and others concerned with deci- sions on policies for national economic growth and development will have to look beyond the financial analysis-at market prices-and form a judgment about the effects of the project on real resources for the econ- omy as a whole. In chapter 7 we take up this issue in the discussion of how to determine economic values. Assessment of incentives The financial analysis is of critical importance in assessing the incen- tives for farmers, managers, and owners (including governments) who FARM INVESTMENT ANALYSIS 87 will participate in the project. Will farm families have an incremental income large enough to compensate them for the additional effort and risk they will incur? Will private sector firms earn a sufficient return on their equity investment and borrowed resources to justify making the investment the project requires? For semipublic enterprises, will the return be sufficient for the enterprises to maintain a self-financing capa- bility and to meet the financial objectives set out by the society? Provision of a sound financing plan A principal objective of the financial analysis is to work out a plan that projects the financial situation and sources of funds of the various project participants and of the project itself. The financial plan provides a basis for determining the amount and timing of investment by farmers and for setting repayment terms and conditions for the credit extended to sup- port the investment. It provides the same basis for an assessment of the investment plans and debt repayment capacities of public and private firms participating in the project. Finally, for the project as a whole, the financial plan is the basis for determining the amount and timing of outside financing-whether from the national treasury or from interna- tional sources-and for establishing how rapidly the borrowed resources should be repaid. The estimated effect of inflation on both revenues and costs should be taken into account in making this assessment. Coordination of financial contributions The financial plan allows the coordination of the financial contribu- tions of the various project participants. The coordination is made on the basis of an overall financial projection for the project as a whole. It addresses itself to such questions as whether the availability of resources from the treasury or international agency is matched with farmers' investment capacities and available funds for investment and operating expenses as well as with the timing of expenditures for project invest- . ments such as feeder roads and irrigation structures and for working capital needed for stocks in processing industries and the like. Assessment of financial management competence On the basis of a projection of the pattern financial accounts, especially for the larger firms and project entities, the analyst can form a judgment about the complexity of the financial management the project will re- quire and about the capability of those who will manage the project's implementation. And from this assessment, the analyst can then judge what changes in organization and management may be necessary if the project is to proceed on schedule and what specialized training may be advisable. Table 4-1. Differences between Farm Income Analysis, Funds Flow Analysis, and Farm Investment Analysis Item Farm income analysis Funds flow analysisa Farm investment analysisb General objective Check current Check farmer's liquidity Check attractiveness performance of farm of additional investment Period usually analyzed Individual years Loan repayment period Useful life of investment Prices used Current prices Current prices Constant prices Treatment Annual depreciation Cash purchases Initial investment, residual of capital charge and sales value 00 Off-farm income Excluded Cash portion included Cash and noncash included 00 Home-consumed farm production Included Excluded Included Performance Return to capital and Cash available to farm Return to additional criteria labor engaged on farm family resources engaged Time value Undiscounted Undiscounted Discounted Performance Profit as a percentage Cash surplus or deficit Net present worth, internal indicators of net worth, family rate of return, benefit-cost ratio, income net benefit-investment ratio, net benefit increase Source: Schaefer-Kehnert (1980). a. Also called sources-and-uses-of-funds analysis. b. Benefit-cost analysis of on-farm investments. FARM INVESTMENT ANALYSIS 89 Preparing the Farm Investment Analysis The starting point for both the financial and the economic analysis of an agricultural project is generally a group of investment analyses of pattern or model farms, based on budgets for individual pattern farms. These pattern farm budgets compare the situation with the project to that anticipated without the project for the duration of the project. They enable the analyst to form a sound judgment about the likely benefit to farmers of participating in an agricultural project and about the incen- tives for farmers to do so. Farm investment analysis is the topic of this chapter. This analysis is similar to, and sometimes confused with, farm management analyses done by agricultural economists, which may be distinguished as farm income analysis and funds flow analysis. The differences are summarized in table 4-1. Farm income analysis is generally used to evaluate the performance of a farm in a particular year. Its objective is to help improve the manage- ment of the farm. Current prices are used, and a depreciation allowance is included to account for that portion of longer-term capital investment used up in the year being considered. Noncash items such as home- consumed production and payments in kind are included. Off-farm in- come and expenditure are excluded because the analysis is intended to evaluate the performance only of the farm itself. The analysis provides an estimate of the return to capital invested and to the farmer's labor, and this may then be compared with the return to alternative cropping patterns or to off-farm opportunities. Funds flow analysis, also called sources-and-uses-of-funds analysis, is used to determine a farmer's liquidity in an analysis of his credit situa- tion. Only cash items, including purchase and sale of capital goods, enter the analysis. Off-farm cash income and expenditure are included, but home-consumed production is not. The analysis shows the cash available to the family over a period of time. Farm investment analysis, in contrast, is undertaken to determine the attractiveness of a proposed investment to farmers and to other partici- pants, including the society as a whole. It projects the effect on farm income of a particular investment and estimates the return to the capital engaged. It follows the principles of discounted cash flow analysis (dis- cussed in detail in chapters 9 and 10). The analysis is projected over the useful life of the investment. The initial investment is shown at the beginning of the projection, and a residual value at the end. In general, the analysis is cast in constant prices, although allowance may have tobe made for inflation. Off-farm income is included. Even though we use the term "cash flow," noncash elements enter the projection, including home-consumed production and payments and receipts in kind. (The term was first applied to industrial investments, in which noncash ele- ments are less common.) When doing farm investment analysis, some 90 FINANCIAL ASPECTS OF PROJECT ANALYSIS elements of funds flow analysis are often incorporated to enable the analyst to assess the farmer's liquidity and his credit use. Those who wish to pursue farm income analysis or funds flow analysis in relation to project analysis may refer to standard farm management texts such as Harsh, Connor, and Schwab (1981) and Kay (1981). Those who want more detail about the application of farm budgets to project analysis may consult Brown (1979). Pattern farm investment analysis that includes farm budgets should be prepared for almost every agricultural project. Although agricultural project analyses that do not have farm budgets are used, it is increasingly accepted that farm budgets are an extremely desirable, if not essential, part of project analysis. The benefit stream of an agricultural project may be built up simply by multiplying the total area to be planted by the expected yield, essentially treating the whole area as one undifferenti- ated farm. If this is all that is done, it may hide crucial information about the effects of the project on individual farmers and obscure underlying unrealistic assumptions. Even when the project involves only a public sector undertaking, a farm budget is likely to be necessary to test the feasibility of the cropping pattern and the financial viability of the enterprise. The purpose in preparing farm investment analyses for a project is not to take a sample of the farms in the project area. Rather, it is to select major farm types expected to participate and to look at the impact of the project on them. These farm investment analyses are usually projections for the life of the project, often twenty to twenty-five years, not for just a single year. The analyst will want to examine the cropping pattern and perhaps to diagram it; to determine the labor that will be required if farmers are to participate in the project and perhaps to prepare a month- by-month labor budget showing requirements and the availability of family labor; to look at production and inputs; and, finally, to prepare a farm budget in the detail needed for understanding and evaluating the effects of the project on the income of participating farmers. From these, the analyst can assess the financial effect of the proposed project on typical farms-both to judge incentives for participation and to deter- mine whether national policies on minimum incomes for project partici- pants are being met. Farm investment analyses and farm budgets can of course be prepared for farms of any size. The problems of analyses for smaller farms are the focus here, since many, if not most, agricultural projects in developing countries will be directed toward smallholders whose families consume a large part of the food they produce. Large commercial farms and plantations, however, whether publicly or privately held, are more like other business enterprises than they are like small, family-operated farms. Projected accounts for these large agricultural undertakings are probably more appropriately cast in for- mal financial statements such as those of the agricultural processing industries discussed in chapter 5. In considering small farms, the analyst will be particularly concerned with the effect of the project on the total income of the farm family. The FARM INVESTMENT ANALYSIS 91 aspects of the small farm as a family unit and as a business firm must be clearly understood and appreciated. These will differ from society to society, and the project analyst should either know the society well enough to anticipate the farmers' response or be advised by others who do. One must assess the attitude of the family to proposed cropping patterns that involve more days of labor, to patterns that increase cash crop output and reduce food crop production below household require- ments, to patterns that change the work responsibilities of men and women, and to patterns that require the family to run a considerable market risk. Farmers are price responsive, of course; the extensive re- search has amply confirmed this (Krishna 1967). But farmers live in a particular cultural and risk environment, and project analysts must take this environment into account when they project their pattern farm investment analyses. Backed by this understanding of the particular cultural environment, the analyst will prepare the farm investment analyses as realistically as possible to determine what the family gains by participating in the project. The projection must be based on a specific package of techno- logical innovation. The effectiveness of the proposed new technology on small farms must be realistically assessed, and the technological assumptions must be checked to ensure that they reflect on-farm condi- tions and not those of an experiment station. The analyst must form a judgment about how rapidly farmers will be willing to adopt new prac- tices. The farm investment analysis should confirm that adoption of a new technology will really be financially worthwhile, for farmers can respond to financial incentives only when it is truly remunerative for them to do so. The analyst must determine how much credit will stimu- late farmers to adopt new practices and must assess how risky a new technology is and how variable the farm income may be under the project. The analyst will want to test the effect of risk on family income by determining what happens if yields fall below expectations or if prices are lower than anticipated and by undertaking similar sensitivity tests. Through such tests a margin to allow for bad years can be built into the farm plan. Although in agricultural projects the analyst generally looks at budgets for entire farms, partial budgeting techniques can be used for undertakings that involve only a relatively minor change in the farm organization. To do this, one looks at the marginal cost (including oppor- tunity cost) of adding a production activity and compares it with the marginal increase in benefit that the new activity will bring. Partial budgets are an effective tool for helping to search out the best combina- tion of production activities. Brown (1979) discusses their use in some detail. In most projects, however, we expect rather substantial changes over a prolonged period, and under these circumstances it is better to project whole farm budgets. Then the total effect of the project on family income can be better assessed. The information on which the project analyst will base his farm invest- ment analysis will come from many sources. Project analysts will have to rely heavily on their professional colleagues to determine a sensible 92 FINANCIAL ASPECTS OF PROJECT ANALYSIS cropping pattern and livestock activity for a proposed project, the output that may be expected, the inputs that will be required, and the relevant prices for products. The project analyst will want to pay particular attention to the realism of the estimates provided by the agriculturalists and livestock specialists he consults. Unrealistic assumptions about yields, input levels, or rates of farmer acceptance and, hence, of buildup in project benefits will negate the best of project analyses. The analyst will certainly want to visit the site of the proposed project and typical farms that will be included. Nothing substitutes for the firsthand knowledge that being there brings. A crucial source of information in every agricultural project is the farmers themselves. Only through interviews with farmers can a project analyst reach a valid conclusion about the realism of his farm investment analysis. The project analyst will want to interview farmers about their present cropping patterns, labor requirements, use of inputs, and the market prices actually received and paid. He will want to gain a sense about the farmers' willingness to participate in the project were it to proceed. In a project area or on a similar site some farmers often are already using a proposed new technology. It is most important that these farmers be interviewed to tap their experience. The analyst will want to know the yields the farmers actually have realized with the new technol- ogy, the inputs they actually must employ, and their general comments on the new technology and cropping pattern proposed for the project. The analyst will want to assess the labor requirements farmers have found necessary to use the new technology. Interviewing farmers is an art in itself, and only a few comments can be made here. The information farmers give will usually be contradictory, but out of a group of interviews the project analyst can gain a sense of feasible technological and financial relations. Farmers will have to be interviewed in the field, not in the office. The analyst will have to know the local measurements and not expect everything to be reported neatly on a unit basis. The analyst or one of his staff should probably conduct the interviews alone or with very few other people around. Great care should be taken to establish a good atmosphere in the interview so that farmers are not overawed by the analyst's presence; farmers should also know that the information they give will not be used for tax purposes. A formal questionnaire may be helpful, especially if much information is to be collected by assistants, but any questionnaire should be carefully pretested in the field before use. It may be better for the analyst or his assistants to fill in the questionnaire only after the interview is complete and the interviewer has left the farmer. In any event, before the inter- views the analyst should have formed a clear idea about the information he needs, perhaps in the form of a list of questions, so that critical information will not be overlooked. Questions put to farmers should be as specific as possible. Most information gathered should relate to actual experience, perhaps in the last cropping season. Questions about hypothetical situations should be avoided to the extent possible. The FARM INVESTMENT ANALYSIS 93 very nature of seeking information about a proposed project will, how- ever, of necessity involve many "what if" kinds of questions. Cropping patterns are usually based on the judgment of the agricultur- alists and livestock specialists working with the project analyst. Their judgment, in turn, will be based on their familiarity with the agriculture of the area, on research results and the results of pilot projects-perhaps undertaken especially as part of the project preparation-and on their knowledge of the farmers who will participate in the project. In most instances, experienced technicians can propose realistic patterns close to the optimum, but sometimes linear programming may be used as a more formal methodology to optimize cropping patterns. Linear program- ming has been applied in preparing agricultural project analyses but is not regularly used either in national planning agencies or in inter- national lending agencies. It is a complex methodology that requires more formal input-output data than does simple budgeting, and in prac- tice it requires computers. There are serious methodological limitations to the use of linear programming for agricultural project analysis: prob- lems of dealing with risk, farmers' cultural traditions, variability of soils within farms, water availability in different areas of a farm, and other farm-level variations. Even so, when preparing a project for an area where there is inadequate experience to rely on in forming subjectively determined cropping patterns or when dealing with very complex pat- terns, the project analyst may want to consult specialists in linear pro- gramming for assistance. In these cases, the project preparation takes on some of the character of a research effort. Because it is a well-known methodology widely used in farm management research, many agri- cultural colleges have staff familiar with linear programming. In most agricultural projects, about half a dozen or so pattern farm investment analyses will suffice, but generalization about this is danger- ous. The number of pattern farm analyses depends entirely on the com- plexity of the project. The analyst will want a pattern farm investment analysis for each major group of soil and water conditions in the project area and for each major difference in the size of holdings. Of course, each major cropping pattern or livestock activity will require a separate farm investment analysis. Remember that the objective is an indication of the effect of the project, not some kind of rigorously drawn, random sample. In practice, the number of farm budgets prepared for any given project analysis is a tradeoff between the complexity of the proposed project and the availability of staff to prepare the investment analyses. Each farm investment analysis will be the result of careful consulta- tion with technical specialists and interviews with farmers. Just as it is not possible to generalize about how many pattern farm budgets will be necessary, neither is it possible to generalize about how many interviews with farmers will be needed. Thorough preparation of a complex project may require twenty-five to fifty or even more interviews to provide the information for each farm analysis. But a simpler project that will use a better-known technology may require only half a dozen to a dozen inter- 94 FINANCIAL ASPECTS OF PROJECT ANALYSIS views for each pattern farm budget. A group doing an appraisal of a proposed project would probably interview fewer farmers than was necessary in the initial project preparation. Each situation will have to be judged by itself in the light of how confident the analyst needs to be about the project analysis, how complex the project is, how well known the technology is, and how available are staff for project preparation. Similar considerations apply in deciding the level of detail necessary in a farm investment analysis. Any farm investment analysis is intended to improve the decisionmaking for a project. It is, of necessity, an ab- straction. This imprecision is forced on us by the very fact that we must predict future events, but it also arises from the question of just how much detail is necessary. In every farm investment analysis, the project analyst will reach a point at which further elaboration or further detail would make such a marginal contribution to the investment decision that it is not worth the time. Just when that point is reached will vary from project to project according to the circumstances of the project and the circumstances of the decisionmaking process. It is easy to conceive of a set of pattern farm investment analyses that would be so enormously detailed and have so many different budgets that the process would quickly become bogged down in detail. Because of staff limitations and because of the approximate nature of the underlying data, it is better to hold both the number of pattern farms and the level of detail to the minimum that will serve to lay out clearly the major points about the project. The project analyst will have to determine how best to present his information so that those who must review his work and make decisions about the project can work efficiently and yet have the information they need. The major entries, the level of detail, and the like will vary from project to project. Some of the elements given in separate tables in the illustrative examples in this chapter may be better combined in the tables that present a particular project. In many project reports, only a summary of background information, plus a detailed farm budget, will be needed. Other, more detailed tables can be included in annexes or in a separate volume of background information reproduced in limited quan- tities and circulated only to those most interested in the project. This kind of additional data can even be kept in a separate project information file that can be made available to anyone seriously interested. (In the Paraguay report used as an example in this chapter, the analyst pre- sented his farm investment analysis in four annex tables and collected the supporting information in a separate project information file.) What we will present here is a pattern format that includes the features most commonly of significance in agricultural project analysis. This pattern format uses a terminology generally accepted by both farm management specialists and accountants. In using the format, the analyst will have to determine for himself, for each project in his charge, exactly how much detail is necessary to support the analysis and exactly how this detail is best reported to facilitate decisions about the particu- lar project. FARM INVESTMENT ANALYSIS 95 Elements of Farm Investment Analysis The principal elements of farm investment analysis are outlined in this subsection and are listed in table 4-2. A flow chart for preparing the analysis is given in figure 4-1. Not every element will be necessary in every analysis, and the means of presenting the elements will vary from project to project according to circumstances. The most important elements of a farm investment analysis can be illustrated by an example adapted from the Paraguay Livestock and Agricultural Development Project. (Tables that illustrate particular ele- ments of the analysis are noted in table 4-2.) The project is to increase agricultural production, productivity, and income on some 940 livestock farms and some 3,000 mixed farms, mostly small, through on-farm in- vestments supported by credit, technical assistance, feeder roads, and market improvement. Most of the important aspects of preparing a farm investment analysis are touched on in this example, but it is clear that no single example can cover every possibility. Each project analyst will want to build on the illustrative tables that outline this one example for the purposes of his own project analysis. As in all accounts, the objectives of the farm investment account determine its content and format. Accounting convention for farm investment analysis Because farm investment analysis follows the principles of discounted cash flow, it is convenient to adopt an accounting convention that is congruent with those principles. [This convention has been called "time- adjusted" by Schaefer-Kehnert (1980), who has elaborated its use.] The discounting process used in discounted cash flow analysis implicitly assumes that every transaction falls at the end of the accounting period. It is desirable that the farm investment analysis match this assumption. This is simply accomplished if we consider the initial investment to take place at the end of year 1 of the project, regardless of whether it will actually take a full year or only a few weeks. Year 2, then, is the first accounting period in which increases in operating cost and incremental benefits occur. Thus, the dividing line between the end of the initial investment period and the beginning of the incremental production operations coincides exactly with the dividing line between years I and 2 of the project. (Some analysts accomplish much the same result by considering investment to fall in year 0, but this gives rise to problems when cash flows are aggregated.) Considering that preparing a farm plan, making a loan, constructing or purchasing investment items, and purchasing new inputs can take at least several months to a year, reserv- ing year 1 for investment is not unrealistic. Doing so, however, is not dictated by real events but by the accounting convention. If all transactions are considered to fall at the end of the accounting period, then we must allow for the availability of the needed operating 96 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 4-2. Principal Elements of Farm Investment Analysis Illustrative Element table Farm resource use Land use 4-4 (Land use calendar) (Figure 4-2) Labor use Annual labor requirement by crop operation, by crop for 1 hectare 4-5 Labor distribution by crop and month, per hectare 4-6 (Labor use diagram) (Figure 4-3) Labor requirement by crop and month 4-7 Hired labor by crop and month 4-8 Off-farm labor Not illustrated Farm production Crops and pasture Yield and carrying capacity 4-9 Crop and pasture production 4-10 Livestock Herd projection 4-27 Herd composition, purchases, sales 4-11 Herd productivity 4-28 Feeding period and daily ration 4-29 Feed requirement and production 4-30 Yield per animal Not illustrated Valuation Farm-gate prices 4-12 Value of production Crops 4-13 Livestock J Incremental residual value 4-14 Farm inputs Investment Physical 4-15 Foreign exchange component Not illustrated Value of investment 4-15 Operating expenditure Crop 4-16 Livestock Incremental working capital 4-17 Farm budget Without project 4-18 With project Net benefit before financing 4-19 Debt service 4-24 Net benefit after financing 4 Cash position 4 Figure 4-1. F1ow Chart for Farm Iпvestment Analysis /nvеггтепг (4-15)' Апnиаl (аЬог reqwsemenl рм hectare Ьу сгор and operanon (4-5) Laбor дгsгпЬиtгоn Labor reqшremenг Hved 1пбог /ncremental by сгор and топгИ, тоnгИ Ьу cro апд monrh per heclare г'�' Р геsгдиаl чаlие 1а�1 f4-71 Г4-81 14-/41 land use (q-qj Орегоипg lncrementa! ezpenduure workгng сариаl Debr servгce (4-16) (4-/7) сотригаlгоn Уге1д and carrymg Сгор and paslure ) b сарасгlу producnon (4-24 V Г4-91 !4-/О) Farrrг-gate pnces �аlие оГ Г4-Ц) Рп�дисггоп £arrn бudgel (4-l 31 га-191 Уге1д рег атта! Feed геqиггетет (пог г(lustratedJ апд ргодисггоп 14-301 WиSоиг-ргоlесг Feedгng репод Гагт бudget and даду ваггоn Негд composmon, (4-/8) (4-29) Негд prolectгon purchases, and sales 14-2�1 !4-l11 Nerd ргодисtгчиу сотритггоп (4-281 ОГ(-Гапп гпсоте (nог dlustrated) а. Numbers in parentheses refer to the гllustrauve [аЫеs т this chapter. 98 FINANCIAL ASPECTS OF PROJECT ANALYSIS expenditure at the beginning of the cropping season. This is accom- plished by incorporating in the analysis an entry for incremental work- ing capital at the end of the preceding year. The amount of the working capital needed is related to the farming system being analyzed. If a single annual crop is produced, then nearly all the operating expenditure will be needed at the beginning of the crop year. But if two crops are to be produced in succession, only the operating expenditure for the first crop need be on hand at the beginning of the crop year, since there will be a harvest during the year that will provide proceeds to replace the input supplies needed before the second crop is harvested. Thus, only half the total annual operating expenditure need be on hand at the beginning of the year. The incremental working capital needed (either an increase or a decrease) at the beginning of the year, then, is entered at the end of the year preceding the year when it will be expended for production. A set of recommended adjustments in incremental operating expenditure to obtain incremental working capital is given in table 4-3. Introducing an incremental working capital stream reflects real resource use. When an investment is undertaken, short-term inputs such as seed, fertilizer, feed, and the like must be on hand. They are replaced from the proceeds of the harvest or livestock sales during the year and are again on hand for production in the following year. If operations are to expand the next year, then stocks of inputs for production must be increased, and this will be reflected in another incremental working capital entry. Since the incremental working capital is entered separately, it will easily be in- cluded in the total investment shown when the farm budget is prepared and will not be inadvertently overlooked. At the end of the project, the incremental working capital for each year is added together algebra- ically and taken out of the project as part of the residual value. Thus, including incremental working capital in the accounts does not result in double counting. One practical outcome of this accounting convention is that operating expenditures and benefits in year 1 generally remain the same as they were without the project. In some cases new investment might require an increase in operating expenditure in year 1, even though production Table 4-3. Incremental Working Capital as a Percentage of Incremental Operating Expenditure Item Percent Tree crops (slowly maturing, one harvest season) 100 Annual crops One season 80-100 Two seasons 40-60 Continuous cropping and continuously producing livestock enterprises 20-40 Source: Schaefer- Kehnert (1980). FARM INVESTMENT ANALYSIS 99 would not be affected until year 2. In other instances, both operating expenditures and production might actually decrease-as might happen if new irrigation canals were to be constructed, disrupting farming op- erations. In laying out the farm investment analysis, however, it is usu- ally considered that working capital is not freed as a result of the invest- ment so that the layout of the farm budget can be simplified. If this were not done, both data for the case without the project and data for a "preproject" year or "year I" would be needed to accommodate the decision rule that working capital be a proportion of the increase or decrease in the operating expenditure for the following year. Showing working capital as a separate entry facilitates determining how much short-term credit may be needed by the farmer. A judgment may be made about whether the farmer will have savings from which to finance increased working capital or whether some proportion or all will have to be covered by extending the farmer a short-term loan, which then can be incorporated into the financing section of the farm budget. The accounting convention adopted here is not much different from that most commonly used by project analysts. The most important dif- ference is the rule of reserving year 1 for investment only and assuming the investment to fall at the end of the year. It is more common to include investment in year 1 but to assume that it will occur at the beginning of the year, even though the discounting process assumes it falls at the end of the year. Production is then assumed to be increased in year 1, an assumption that leads to an overestimate of the rate of return on the capital used. It also leads to a considerable overestimate of the farmer's income in the early years of the project and, hence, to an underestimate of his need for both long-term and short-term credit. The other difference between the accounting convention adopted here and that most com- monly used by project analysts is only a matter of completeness. It is easy inadvertently to omit or underestimate working capital unless such capital is included in the convention. This convention for working capital leaves the crop year intact and therefore facilitates the supporting tech- nical projections. Farm resource use Once the agronomists, livestock technicians, and other technical spe- cialists have determined the components of a proposed farming system for a pattern farm, the analyst may proceed to prepare the farm invest- ment analysis. LAND USE. The first step is to determine what the land use on the farm will be. The land use for the Paraguay project is given in table 4-4. Note that the crop year is taken to extend from July of one calendar year to June of the next, since this arrangement makes the break in the year come during the Paraguayan winter season, when there are the fewest crops in the ground. The total farm area is 20.0 hectares, divided into cultivated area, pasture, forest, and a house plot. (Throughout the text of this chapter, 100 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 4-4. Land Use, 20-Hectare Mixed Farm, Livestock and Agricultural Development Project Model IV, Paraguay (hectares) With project Type of use Without and cropa project Year 1 2 3 4 5 6-20 Cultivated area Maizeb 0.5 0.5 0.5 0.5 0.5 0.5 0.5 Maniocb 1.0 1.0 1.0 1.0 0.5 0.5 0.5 Beans 0.5 0.5 0.5 0.5 0.5 0.5 0.0 Cotton 2.0 2.0 2.0 2.0 2.2 2.5 3.0 Soybeans 0.0 0.0 1.0 1.0 2.2 2.5 3.0 Sunflower' 00 0.0 2 0 2.0 2.2 2.5 3.0 Total 4.0 4.0 7.0 7.0 8.1 9.0 10.0 Total croplandd 4.0 4.0 5.0 5.0 5.9 6.5 7.0 Cropping intensitye 1 0 1.0 1.4 1.4 1 4 1.4 1.4 Pasture Natural 10.5 7 0 3 5 0.0 0.0 0.0 0 0 Improved 0.0 3.5 7.0 10.5 10.5 10.5 10.5 Total 10.5 10.5 105 10.5 10.5 10.5 10.5 Forest 5.0 5.0 4.0 4.0 3.1 2.5 2.0 House plot 0.5 0.5 0.5 0.5 0.5 0.5 0.5 Total farm area 20 0 20.0 20 0 20.0 20.0 20.0 20.0 Source: Adapted from World Bank, "Staff Appraisal Report: Paraguay-Livestock and Agricultural Development Project," 2272-PA (Washington, D.C., 1979; restricted circula- tion), annex 1, table 17. a. Operated by one family with six members and a work potential of 70 work days a month. A work day is the time (generally eight hours) devoted by one person during one day. b. Maize and manioc are intercropped. c. Double-cropped after cotton or soybeans. The area given is the area planted in the year shown. d. Does not include second crop area, in this case the area planted in sunflower. e. Cropping intensity is determined by dividing the total cultivated area by the total cropland. the most common or generalized categories from the pattern tables will be shown in italic type. These items would be considered in any farm investment analysis. In all tables the generalized analytical framework applies, but in some the categories are all specific to the project analyzed.) The land use, in accord with the accounting convention adopted, would remain unchanged in year 1, except for establishment of improved pasture that is part of the investment. In year 2, in which the proposed cropping pattern calls for sunflower to be introduced and to be double- cropped after either cotton or soybeans (depending on the year), both the total cultivated area and the total cropland are shown. The total culti- vated area is the total area planted in crops, whereas the total cropland is the area available to cultivate. When the total cultivated area is divided by the total cropland, the cropping intensity is obtained. In year 2, for FARM INVESTMENT ANALYSIS 101 example, the cropping intensity is 1.4 (7.0 - 5.0 = 1.4). Many analysts prefer to report cropping intensity in percentages, so this would be reported as 140 percent. One check of the feasibility of the cropping pattern is the intensity. The analyst should be cautious about accepting a cropping pattern that has a very high cropping intensity or one that is markedly different from the pattern existing in the area. Farmers may well have good reasons for not driving up the intensity. Many analysts also like to devise a cropping diagram, such as that given in figure 4-2, and this should be subdivided to indicate any existing farm plots. Such a diagram is usually drawn up only for the full- development situation. The diagram indicates the area to be devoted to each category of land use and each crop. In the case of our example, it extends over two years to show that the seasonal timing of the cotton- sunflower-soybean rotation occurs on one plot in one year and on another in the next. Checking vertically at any one time, we can be sure the cropping pattern does not call for more area than the farm has. Checking horizontally, we can determine when each crop must be planted and whether enough land will be available at the proper season. The left and right sides of the boxes showing the area to be planted in each crop are slanted to indicate the planting and harvest time necessary for each crop. Examining the cropping diagram can help determine if there will be adequate time between crops to prepare the land. Figure 4-2. Land Use Calendar for Project Years 6-20, 20-Hectare Mixed Farm, Livestock and Agricultural Development Project, Paraguay 2C -Forest 19- (2.0 ha) 6 18 17- 16- 15- 14- Improved 13- pasture 5 0 m 12 - (10.5 ha) E S11 10- Sun- 9 - Sunflower flower 8 - (3.0 ha) (3.0 ha) 7- 6 - oybeans Cotton 4 5 - (3.0 ha) (3.0 ha) Cropland 4 - Cotton Sunflower Soybeans (7.0 ha) 33 2 (3.0 ha) (3.0 ha) (3.0 ha) 1 -Maize an manioc (1.0 a) House 2 0 - -plot I JIAISIOINIDIJIIMIAIMIJIJIAISIOINIDIJF A (0.5 ha) Montha ha Hectares. Source: Table 4-4. a. Crop year is from July to June. 102 FINANCIAL ASPECTS OF PROJECT ANALYSIS LABOR USE. A second aspect of the farm resource use is labor. To determine the labor the farm will require, we need to know the labor used to cultivate a hectare of each crop in each project year. It is desirable to be able to see this in two forms, by operation and by month. Table 4-5 shows the annual labor requirements for 1 hectare by crop and operation for the Paraguay project example. It includes the labor required not only for the various crops to be produced, but also for the pasture. The labor unit is a work day, the time (generally eight hours) devoted by one person during one day. The labor requirement for crops drops sharply between years 1 and 2 because of the introduction of draft animal power. In the case of pasture, the labor requirement for fencing and seeding is included in years 1 through 3. In the Paraguay model, other activities of pasture establishment are to be undertaken by a contractor, so there will be no call for labor from the farmer. If, however, labor for establishing some other kind of improvement were expected, such as farmers' digging their own tertiary canals in an irrigation project, then this should be included in the labor requirement. Table 4-5. Annual Labor Requirement per Hectare by Crop and Operation, 20-Hectare Mixed Farm, Paraguay Project (work days) With project Without Crop and operation project Year 1 2 3 4 5 6 7-20 Crops Maize Land preparation and planting 22 22 11 11 11 11 11 11 Cultivationa 9 9 2 2 2 2 2 2 Harvesting 28 28 28 31 31 33 33 36 Total 59 59 41 44 44 46 46 49 Manioc Land preparation and planting 14 14 10 10 10 10 10 10 Cultivationa 27 27 15 15 15 15 15 15 Harvesting 19 19 19 21 21 23 23 25 Total 60 60 44 46 46 48 48 50 Beans Land preparation and planting 24 24 19 19 19 19 19 19 Cultivation 10 10 4 4 4 4 4 4 Harvesting 20 20 20 22 22 22 22 22 Total 54 54 43 45 45 45 45 45 Cotton Clearing 8 8 8 8 8 8 Plowing 18 18 3 3 3 3 3 3 Harrowing (2 times) 2 2 2 2 2 2 Seeding 4 4 1 1 1 1 1 1 Thinning 6 6 6 6 6 6 6 6 Cultivation (3 times) 30 30 3 3 3 3 3 3 Spraying (5 times) 10 10 10 10 10 10 10 10 Harvesting 37 37 43 43 46 46 49 49 Drying, packing, marketing 4 4 4 4 4 4 4 4 Total 109 109 80 80 83 83 86 86 FARM INVESTMENT ANALYSIS 103 Table 4-5 (continued) With project Without Crop and operation project Year 1 2 3 4 5 6 7-20 Soybeans Clearing - - 8 8 8 8 8 8 Plowing - - 3 3 3 3 3 3 Harrowing (2 times) - - 2 2 2 2 2 2 Seeding - - 1 1 1 1 1 1 Thinning - - 6 6 6 6 6 6 Cultivation (2 times) - - 2 2 2 2 2 2 Spraying (2 times) - - 4 4 4 4 4 4 Harvesting - - 18 18 20 20 22 22 Transport - - 3 3 3 3 4 4 Total - - 47 47 49 49 52 52 Sunflower Clearing - - 6 6 6 6 6 6 Plowing - - 3 3 3 3 3 3 Harrowing (2 times) - - 2 2 2 2 2 2 Sowing - - 1 1 1 1 1 1 Thinning - - 6 6 6 6 6 6 Cultivation (2 times) - - 2 2 2 2 2 2 Spraying (2 times) - - 4 4 4 4 4 4 Harvesting - - 13 14 14 15 15 15 Drying, packing, marketing - - 4 4 4 5 5 5 Total - - 41 42 42 44 44 44 Pasture Improved establishment Fencing - 7 7 7 0 0 0 0 Seeding - 2 2 2 0 0 0 0 Maintenance - - 3 3 3 3 3 3 Note: For the area in various crops, see table 4-4. Source: Adapted from A. 0. Ballantyne, "Paraguay-Small Farmer Credit Component, Livestock and Agricultural Development Project," working papers on file (Washington, D.C.: World Bank, 1978; restricted circulation). a. Maize and manioc are intercropped. Hence, during the period when both are growing, the allocation of cultivation time between the two crops has an arbitrary element. The total labor requirement per hectare for each crop is distributed by month in table 4-6. The monthly distribution is most important because we must determine not only the total annual labor requirement on the farm but also its timing to assess whether sufficient family labor will be available and, if there is not enough, how much hired labor will be needed. Although some farm management analysts break down the labor requirement by week or fortnight, for purposes of project analysis the monthly distribution is sufficient. On a mixed farm, livestock will also require labor. This may be calcu- lated by determining how much time will be needed per animal unit in the livestock herd. An animal unit is a measurement of feed demand by a particular class of animal. (This is discussed in more detail in the appen- dix to this chapter. The total animal units for each year are reported in table 4-11. They are given in that table for the livestock herd that could exist on 100 model farms to avoid the problem of divisibility that arises 104 FINANCIAL ASPECTS OF PROJECT ANALYSIS when the increase in large livestock on a small farm is projected. Thus, to obtain the animal units on one farm, the total reported in table 4-11 must be divided by 100. We will return to a discussion of this convention in the next subsection, when we discuss the herd composition.) In the Paraguay example, it is assumed that each animal unit will require five minutes of care a day and that the requirement will be the same each month throughout the year. The labor requirement is determined on the basis of the animal units at the beginning of the year. Using animal units rather Table 4-6. Labor Distribution by Crop and Month, 20-Hectare Mixed Farm, Paraguay Project (work days per hectare) Crop Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Total Maizea Without project, year 1 14 8 0 5 4 28 0 0 0 0 0 0 59 Year 2 9 2 0 1 1 28 0 0 0 0 0 0 41 Years 3-4 9 2 0 1 1 31 0 0 0 0 0 0 44 Years 5-6 9 2 0 1 1 33 0 0 0 0 0 0 46 Years 7-20 9 2 0 1 1 36 0 0 0 0 0 0 49 Manioca Without project, year 1 0 0 14 3 3 3 4 3 5 3 3 19 60 Year2 0 0 10 2 2 1 2 2 2 2 2 19 44 Years 3-4 0 0 10 2 2 1 2 2 2 2 2 21 46 Years 5-6 0 0 10 2 2 1 2 2 2 2 2 23 48 Years 7-20 0 0 10 2 2 1 2 2 2 2 2 25 50 Beans without project, year 1 0 0 0 0 24 5 5 20 0 0 0 0 54 Year 2 0 0 0 0 19 2 2 20 0 0 0 0 43 Years 3-5 0 0 0 0 19 2 2 22 0 0 0 0 45 Cotton Without project, year I 0 0 8 14 8 19 19 7 20 14 0 0 109 Years 2-3 0 0 8 6 8 6 5 8 25 14 0 0 80 Years 4-5 0 0 8 6 8 6 5 8 27 15 0 0 83 Years 6-20 0 0 8 6 8 6 5 9 28 16 0 0 86 Soybeans Years 2-3 0 0 0 0 13 8 3 2 10 8 3 0 47 Years 4-5 0 0 0 0 13 8 3 2 10 10 3 0 49 Years 6-20 0 0 0 0 13 8 3 2 11 11 4 0 52 Sunflowerb Year 2 2 9 3 13 4 0 0 0 0 0 6 4 41 Years 3-4 2 9 3 14 4 0 0 0 0 0 6 4 42 Years 5-20 2 9 3 15 5 0 0 0 0 0 6 4 44 Pasture Improved establishment Fencing 2 5 0 0 0 0 0 0 0 0 0 0 7 Seeding 0 0 0 0 2 0 0 0 0 0 0 0 2 Maintenance 0 0 0 0 0 0 0 1 0 0 1 1 3 Note: Same as table 4-5. Source: Same as table 4-5. a. See note a, table 4-5. b. Labor requirements for sunflower apply to the year of planting. Thus, in year 2 the labor requirement is for the crop planted in May of year 2 and harvested in October of year 3. FARM INVESTMENT ANALYSIS 105 than each individual class of animal as the basis for estimating the labor requirement considerably simplifies the computation and is not un- realistic. In the convention recommended here, for example, closing livestock figures do not include heifers two to three years old or steers sold during the year, in this case steers three to four years old. Opening livestock figures, however, omit calves. In reality, closing and opening figures tend to balance each other, since heifers will be transferred to the breeding herd throughout the year and surplus heifers and steers will be sold throughout the year, whereas calves will be born throughout the year. Attempting a more precise estimate would only lead to superficial precision because the error in estimating the daily requirement for labor considerably exceeds any gain in accuracy. Having determined the labor requirement for each crop or animal unit by month, we proceed to calculate the labor requirement for the pattern farm. This is given for the Paraguay example in table 4-7. Here the labor required for each crop during each project year is given. The total by month and the amount to be provided by family labor and by hired labor are determined. In the Paraguay example, it is assumed that the family on the pattern farm will have available 70 work days of labor a month and that any labor requirement in excess of this amount will be supplied by hired labor. This is a very mechanistic assumption, of course. Not only will families vary widely in the labor they have available-even on farms of quite comparable size and cropping pattern-but families will also tend to work longer hours in busy seasons and rest in the off-season. For purposes of the farm investment analysis, however, this approximation is quite sufficient, given the wide margin of error in the estimates of the labor requirement in general. In the Paraguay example, table 4-7 shows that hired labor will be needed on the farm from year 4 onward. By year 7, in the peak month of March, about 44 percent of the total labor required for cotton and soybeans will have to be hired. When a labor budget shows a need for hired labor, as this example does, the project analyst must consider carefully whether the labor will be available in the project area. Totaling the hired labor requirement for the project as a whole is one of the real advantages of including the labor budget in the farm investment analysis, since the analyst must then consider the realism of the proposed pattern in light of the added hired labor that can reasonably be expected to be available in the project area. Postulating 56 additional work days of hired labor in March is one thing; whether such additional labor would be available for an entire proposed project is another. It may be that a proposed cropping pattern will prove unrealistic in its requirements of additional hired labor, and a less labor-intensive cropping pattern must be proposed. Furthermore, if the project will call for substantial amounts of additional hired labor in relation to the supply available in the region, this may have implications about the sources from which the labor must be drawn and, hence, about the opportunity cost of the hired labor. In turn, this opportunity cost will have to be considered when making the estimates of the economic value of the labor (see chapter 7). Table 4-7. Labor Requirement by Crop and Month, 20-Hectare Mixed Farm, Paraguay Project (work days) Year and crop or activity Unit Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Total Without project Maize 0.5 ha 7 4 0 2 2 14 0 0 0 0 0 0 29 Manioc 1.0 ha 0 0 14 3 3 3 4 3 5 3 3 19 60 Beans 0.5 ha 0 0 0 0 12 2 2 10 0 0 0 0 26 Cotton 2.0 ha 0 0 16 28 16 38 38 14 40 28 0 0 218 Livestocka 13.6 a.u. 4 4 4 4 4 4 4 4 4 4 4 4 48 Total 11 8 34 37 37 61 48 31 49 35 7 23 381 Family laborb 11 8 34 37 37 61 48 31 49 35 7 23 381 Hired labor 0 0 0 0 0 0 0 0 0 0 0 0 0 Year I Maize 0.5 ha 7 4 0 2 2 14 0 0 0 0 0 0 29 Manioc 1.0 ha 0 0 14 3 3 3 4 3 5 3 3 19 60 Beans 0.5 ha 0 0 0 0 12 2 2 10 0 0 0 0 26 Cotton 2.0 ha 0 0 16 28 16 38 38 14 40 28 0 0 218 Livestock 13.6 a.u. 4 4 4 4 4 4 4 4 4 4 4 4 48 Improved pasture Fencing and seeding 3.5 ha 7 18 0 0 7 0 0 0 0 0 0 0 32 Total 18 26 34 37 44 61 48 31 49 35 7 23 413 Family labor 18 26 34 37 44 61 48 31 49 35 7 23 413 Hired labor 0 0 0 0 0 0 0 0 0 0 0 0 0 Year 2 Maize 0.5 ha 4 1 0 0 0 14 0 0 0 0 0 0 19 Manioc 1.0 ha 0 0 10 2 2 1 2 2 2 2 2 19 44 Beans 0.5 ha 0 0 0 0 10 1 1 10 0 0 0 0 22 Cotton 2.0 ha 0 0 16 12 16 12 10 16 50 28 0 0 160 Soybeans 1.0 ha 0 0 0 0 13 8 3 2 10 8 3 0 47 Sunflower' 2.0 ha 0 0 0 0 0 0 0 0 0 0 12 8 20 Livestock 17.2 a.u. 5 5 5 5 5 5 5 5 5 5 5 5 60 Improved pasture Fencing and seeding 3.5 ha 7 18 0 0 7 0 0 0 0 0 0 0 32 Maintenanced 3.5 ha 0 0 0 0 0 0 0 4 0 0 4 4 12 Total 16 24 31 19 53 41 21 39 67 43 26 36 416 Family labor 16 24 31 19 53 41 21 39 67 43 26 36 416 Hired labor 0 0 0 0 0 0 0 0 0 0 0 0 0 Year 3 Maize 0.5 ha 4 1 0 0 0 16 0 0 0 0 0 0 21 Manioc 1.0 ha 0 0 10 2 2 1 2 2 2 2 2 21 46 Beans 0.5 ha 0 0 0 0 10 1 1 11 0 0 0 0 23 Cotton 2.0 ha 0 0 16 12 16 12 10 16 50 28 0 0 160 Soybeans 1.0 ha 0 0 0 0 13 8 3 2 10 8 3 0 47 Sunflower 2.0 ha 4 18 6 26 8 0 0 0 0 0 12 8 82 Livestock 19.9 a.u. 6 6 6 6 6 6 6 6 6 6 6 6 72 Improved pasture Fencing and seeding 3.5 ha 7 18 0 0 7 0 0 0 0 0 0 0 32 Maintenance 7.0 ha 0 0 0 0 0 0 0 7 0 0 7 7 21 Total 21 43 38 46 62 44 22 44 68 44 30 42 504 Family labor - 21 43 38 46 62 44 22 44 68 44 30 42 504 Hired labor 0 0 0 0 0 0 0 0 0 0 0 0 0 (Table continues on following pages.) Table 4-7 (continued) Year and crop or activity Unit Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Total Year 4 Maize 0.5 ha 4 1 0 0 0 16 0 0 0 0 0 0 21 Manioc 0.5 ha 0 0 5 1 1 0 1 1 1 1 1 10 22 Beans 0.5 ha 0 0 0 0 10 1 1 11 0 0 0 0 23 Cotton 2.2 ha 0 0 18 13 18 13 11 18 59 33 0 0 183 Soybeans 2.2 ha 0 0 0 0 29 18 7 4 22 22 7 0 109 Sunflower 2.2ha 4 18 6 28 8 0 0 0 0 0 13 9 86 Livestock 22.7 a.u. 7 7 7 7 7 7 7 7 7 7 7 7 84 Improved pasture oa Maintenance 10.5 ha 0 0 0 0 0 0 0 10 0 0 10 10 30 Total 15 26 36 49 73 55 27 51 89 63 38 36 558 Family labor 15 26 36 49 70 55 27 51 70 63 38 36 536 Hired labor 0 0 0 0 3 0 0 0 19 0 0 0 22 Year 5 Maize 0.5 ha 4 1 0 0 0 16 0 0 0 0 0 0 21 Manioc 0.5 ha 0 0 5 1 1 0 1 1 1 1 1 12 24 Beans 0.5 ha 0 0 0 0 10 1 1 11 0 0 0 0 23 Cotton 2.5 ha 0 0 20 15 20 15 12 20 68 38 0 0 208 Soybeans 2.5 ha 0 0 0 0 32 20 8 5 25 25 8 0 123 Sunflower 2.5 ha 4 20 7 31 9 0 0 0 0 0 15 10 96 Livestock 24.6 a.u. 8 8 8 8 8 8 8 8 8 8 8 8 96 Improved pasture Maintenance 10.5 ha 0 0 0 0 0 0 0 10 0 0 10 10 30 Total 16 29 40 55 80 60 30 55 102 72 42 40 621 Family labor 16 29 40 55 70 60 30 55 70 70 42 40 577 Hired labor 0 0 0 0 10 0 0 0 32 2 0 0 44 Year 6 Maize 0.5 ha 4 1 0 0 0 16 0 0 0 0 0 0 21 Manioc 0.5 ha 0 0 5 1 1 0 1 1 1 1 1 12 24 Cotton 3.0 ha 0 0 24 18 24 18 15 27 84 48 0 0 258 Soybeans 3.0 ha 0 0 0 0 39 24 9 6 33 33 12 0 156 Sunflower 3.0 ha 5 22 8 38 12 0 0 0 0 0 18 12 115 Livestock 25.1 a.u. 8 8 8 8 8 8 8 8 8 8 8 8 96 Improved pasture Maintenance 10.5 ha 0 0 0 0 0 0 0 10 0 0 10 10 30 Total 17 31 45 65 84 66 33 52 126 90 49 42 700 Family labor 17 31 45 65 70 66 33 52 70 70 49 42 610 Hired labor 0 0 0 0 14 0 0 0 56 20 0 0 90 Years 7-20 Maize 0.5 ha 4 1 0 0 0 18 0 0 0 0 0 0 23 Manioc 0.5 ha 0 0 5 1 1 0 1 1 1 1 1 12 24 Cotton 3.0 ha 0 0 24 18 24 18 15 27 84 48 0 0 258 Soybeans 3.0 ha 0 0 0 0 39 24 9 6 33 33 12 0 156 Sunflower 3.0 ha 6 27 9 45 15 0 0 0 0 0 18 12 132 Livestock 25.0 a.u. 8 8 8 8 8 8 8 8 8 8 8 8 96 Improved pasture Maintenance 10.5 ha 0 0 0 0 0 0 0 10 0 0 10 10 30 Total 18 36 46 72 87 68 33 52 126 90 49 42 719 Family labor 18 36 46 70 70 68 33 52 70 70 49 42 624 Hired labor 0 0 0 2 17 0 0 0 56 20 0 0 95 ha Hectares; a.u. animal units. b. Assumes 70 work days per month of available family labor. Source: Calculated from tables 4-4 and 4-6. c. Area and labor requirement for sunflower apply to the year of planting. a. Assumes five minutes a day per animal unit, eight hours a day, and thirty Thus, the area assumed in the first five months of project year 5 is the 2.2 days a month. The labor requirement is based on the animal units at the hectares planted in May of project year 4. beginning of the year (as given in table 4-11) divided by 100 to give the labor d. Calculated on the basis of improved pasture established in previous requirement for a single farm. See text (the subsection "Farm production. years (as shown in table 4-4). Thus, in year 2 it is based on 3.5 hectares and in Livestock") for a discussion of this convention. year 3 on 7.0 hectares. 110 FINANCIAL ASPECTS OF PROJECT ANALYSIS Some analysts like to work out a labor use diagram such as the one shown in figure 4-3. This usually is done only for the full-development situation. The graphic presentation makes the problem of peak labor requirements readily apparent. Once the total hired labor has been determined, it must be allocated among the various crops so that it may be included in the proper category of operating expenditure. This is done in table 4-8. In the Paraguay example the allocation is made in proportion to the total work days Figure 4-3. Labor Use Diagram for Project Years 7-20, 20-Hectare Mixed Farm, Paraguay Project 130 120- 110- 100- 90- 80- Family - labor S 70 - - - -- - - -- - - 0 60- 50- 40- 30- 20- 10ol Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Month Crop Total E2 Cotton 0 0 24 18 24 18 15 27 84 48 0 0 258 15 Soybeans 0 0 0 0 39 24 9 6 33 33 12 0 156 M Sunflower 6 27 9 45 15 0 0 0 0 0 18 12 132 EM Maize 4 1 0 0 0 18 0 0 0 0 0 0 23 CD Manioc 0 0 5 1 1 0 1 1 1 1 1 12 24 E3 Improved pasture maintenance 0 0 0 0 0 0 0 10 0 0 10 10 30 W Livestock 8 8 8 8 8 8 8 8 8 8 8 96 Total 18 36 46 72 87 68 33 52 126 90 49 42 719 Family labor 18 36 46 70 70 68 33 52 70 70 49 42 624 Hired labor 0 0 0 2 17 0 0 0 56 20 0 0 95 Source: Table 4-7. FARM INVESTMENT ANALYSIS ill required for each cash crop in each month for which hired labor would be needed. In other circumstances, such a mechanistic allocation would be inappropriate. In many areas, certain crop operations are done by hired labor and not by family labor, even if family labor is available. Thus, in Southeast Asia, transplanting rice is done in many areas entirely by hired labor; the only family labor engaged is that of the farmer himself, who supervises the work. Both the amount of hired labor and its allocation among crops should be closely related to the expected cultural practices of people in the project area. Farm production Having determined the use of land and labor resources for the pattern farm, the analyst next assesses the projected farm production. The in- vestment analysis of crop and pasture and livestock production is dis- cussed in this subsection, and issues of valuation (both of farm produc- tion and incremental residual value on the farm) are addressed. Table 4-8. Hired Labor by Crop and Month, 20-Hectare Mixed Farm, Paraguay Project (work days) Year and cropa Jul Aug Sept Oct Nov Dec Jan Feb Mar Apr May Jun Total Year 4 Cotton 0 0 0 0 1 0 0 0 14 0 0 0 15 Soybeans 0 0 0 0 2 0 0 0 5 0 0 0 7 Total 0 0 0 0 3 0 0 0 19 0 0 0 22 Year 5 Cotton 0 0 0 0 3 0 0 0 23 1 0 0 27 Soybeans 0 0 0 0 5 0 0 0 9 1 0 0 15 Sunflower 0 0 0 0 1 0 0 0 0 0 0 0 1 Total 0 0 0 0 9b 0 0 0 32 2 0 0 43b Year 6 Cotton 0 0 0 0 4 0 0 0 40 12 0 0 56 Soybeans 0 0 0 0 7 0 0 0 16 8 0 0 31 Sunflower 0 0 0 0 2 0 0 0 0 0 0 0 2 Total 0 0 0 0 13b 0 0 0 56 20 0 0 89b Years 7-20 Cotton 0 0 0 1 5 0 0 0 40 12 0 0 58 Soybeans 0 0 0 0 8 0 0 0 16 8 0 0 32 Sunflower 0 0 0 1 3 0 0 0 0 0 0 0 4 Total 0 0 0 2 16b 0 0 0 56 20 0 0 94b Source: Calculated from table 4-7. a. Hired labor is allocated to cash crops-cotton, soybeans, and sunflower-in propor- tion to their total labor requirements in that month. In November of year 4, for example, 55 work days are required for cash crops, of which 3 work days are to be hired. Eighteen work days are required for cotton. To determine the hired labor for cotton, the proportion of total labor required for cash crops that is to be applied to cotton is multiplied by the total hired labor requirement for the month; this gives the hired labor to be applied to cotton, or I work day {[18 + (18 + 29 + 8)] x 3 = I}. b. Does not equal the total in table 4-7 because of rounding. 112 FINANCIAL ASPECTS OF PROJECT ANALYSIS CROPS AND PASTURE. For crops and pasture, the yield and carrying capacity are tabulated as illustrated in table 4-9. In the table, yields are shown only for crops and pasture actually in the cropping pattern in the year reported. Thus, no without-project yield is reported for soybeans, whereas for sunflower, which will be planted following cotton in year 2, yield is reported only beginning in year 3 since the first crop is not harvested until that time. Multiplying the production per hectare by the number of hectares of each of the crops and of pasture in the land use pattern shown in table 4-4, we obtain the crop and pasture production illustrated in table 4-10. Again, since sunflower is first planted in year 2 but first harvested in year 3, the production from the first planting of 1.8 tons is shown in year 3. Similarly, sunflower planted each year produces in the following year. Because all the feed for the livestock to be produced on the pattern farm in the Paraguay project is assumed to come from pasture, no deduction is made in table 4-10 for crops to be used for feed. Should the production pattern of a model farm call for the use of crops and crop by-products for feed, table 4-10 would then be adjusted to show that use. Total production of crops would be shown and expanded to include crop by-products if these were to be fed or if they have a sale value. From this total would be deducted the feed consumption taken from an estimate of feed requirement and production such as that illustrated in table 4-30. The result would be the net production available for sale or household consumption. LIVESTOCK. Herd composition, purchases, and sales are given in table 4-11. Projecting the herd (or flock) composition, purchases, and sales in a farm investment analysis that involves livestock introduces a computa- tional process that can become quite complex. Table 4-9. Yield and Carrying Capacity, 20-Hectare Mixed Farm, Paraguay Project With project Without Product project Year 1 2 3 4 5 6 7-20 Crops (tons per hectare) Maize 1.1 1.1 1.1 1.2 1.2 1.3 1 3 1.4 Mamoc 18.0 18.0 18.0 20.0 20.0 22.0 22.0 24.0 Beans 0.9 0.9 0.9 1.0 1.0 1.0 - - Cotton 1.3 1.3 1.5 1.5 1.6 1.6 1.7 1.7 Soybeans - - 1.4 1.4 1.6 1.6 1.8 1.8 Sunflower - - - 0.9 1.0 1.1 1.2 1.2 Pasture (animal units per hectare) Natural 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 Improved - 2.5 2.5 2.5 2.5 2.5 2.5 2.5 Source: Same as table 4-4. FARM INVESTMENT ANALYSIS 113 Table 4-10. Crop and Pasture Production, 20-Hectare Mixed Farm, Paraguay Project (tons) With project Without Product project Year 1 2 3 4 5 6 7-20 Crops Total production Maize 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.7 Manioc 18.0 18.0 18.0 20.0 10.0 11.0 11.0 12.0 Beans 0.4 0.4 0.4 0.5 0.5 0.5 - - Cotton 2.6 2.6 3.0 3.0 3.5 4.0 5.1 5.1 Soybeans - - 1.4 1.4 3.5 4.0 5.4 5.4 Sunflower' - - - 1.8 2.0 2.4 3.0 3.6 Feed consumption b Maize - - - - - - - - Manioc - - - - - - - - Soybeans - - - - - - - - Sunflower - - - - - - - - Net production available for sale or house- hold consumption Maize 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.7 Manioc 18.0 18.0 18.0 20.0 10.0 11.0 11.0 12.0 Beans 0.4 0.4 0.4 0.5 0.5 0.5 - - Cotton 2.6 2.6 3.0 3.0 3.5 4.0 5.1 5.1 Soybeans - - 1.4 1.4 3.5 4.0 5.4 5.4 Sunflower - - - 1.8 2.0 2.4 3.0 3.6 Pasture Carrying capacity (animal units) 12.6 17.2 21.7 26.2 26.2 26.2 26.2 26.2 Source: Calculated from tables 4-4 and 4-9. a. Sunflower is harvested in the year following planting. Thus, the production in year 2 is zero, and in year 3 it is 1.8 tons, which is determined by multiplying the 2.0 hectares planted in year 2 by the yield of 0.9 tons per hectare harvested in year 3 (2.0 x 0.9 = 1.8). b. If there were a substantial livestock production activity on the farm that used crops for feed, the amounts would be estimated in a feed requirement and production table such as table 4-30 and tabulated here. The table would be expanded to include crop by-products used for feed. As indicated, the use of crops for feed would be deducted from the total production, and the result would be the net production available for sale or household consumption. Herd projections are done to forecast use of future facilities, pasture, or feed by applying technical coefficients, such as those shown at the bottom of table 4-11, to trace the changes in the size and composition of the herd. For poultry, stall feeding, or feedlot projections, it is usually assumed that enough young animals can be purchased in a given year to bring the numbers up to the level of feed availability or of proposed production facilities. Brown (1979, pp. 76-85) gives a methodology for broiler and egg production. For pigs, a projection is made applying the technical coefficients; since the gestation period of swine is short, the projection is simplified and uncomplicated. 114 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 4-11. Herd Composition, Purchases, and Sales, 100 20-Hectare Mixed Farms, Paraguay Project (head) With project Without Item project Year 1 2 3 4 5 6 7-20 Herd composition at beginning of year Bulls 100 100 100 100 100 100 100 100 Breeding cows 500 500 655 800 800 800 800 800 Heifers 1-2 years 157 157 157 221 294 285 285 285 Heifers 2-3 years 152 152 152 152 217 288 279 279 Steers 1-2 years 157 157 157 221 294 285 285 285 Steers 2-3 years 152 152 152 152 217 288 279 279 Steers 3-4 years 147 147 147 147 149 213 282 273 Work oxen - 0 200 200 200 200 200 200 Total 1,365 1,365 1,720 1,993 2,271 2,459 2,510 2,501 Animal units 1,365 1,365 1,720 1,993 2,271 2,459 2,510 2,501 Carrying capacity (beginning of year)a 1,260 1,260 1,720 2,170 2,620 2,620 2,620 2,620 Purchases Bulls 18 33 20 20 20 20 20 20 Heifers 2-3 years 0 91 131 2 0 0 0 0 Steers 1-2 years 0 0 0 0 0 0 0 0 Work oxen 0 200 38 36 36 36 36 36 Total 18 324 189 58 56 56 56 56 Sales (including culls) Culled bulls 15 30 17 18 18 18 18 18 Culled cows 60 60 98 120 112 112 112 112 Culled heifers 8 8 15 15 22 29 28 28 Surplus heifers 2-3 years 64 0 0 0 63 125 117 117 Steers 1-2 years 0 0 0 0 0 0 0 0 Steers 3-4 years 143 143 143 144 146 209 276 268 Culled work oxen - 0 32 32 32 32 32 32 Total 290 241 305 329 393 525 583 575 Herd productivity (percent)b 20 23 Technical coefficients (percent) Calving rate 70 70 75' 80' 75 75 75 75 Calf mortality 10 10 10 8 5 5 5 5 Adult mortality 3 3 3 2 2 2 2 2 Culling rate (bulls) 15 30 17 18 18 18 18 18 Culling rate (cows) 12 12 15 15 14 14 14 14 Culling rate (heifers) 5 5 10 10 10 10 10 10 Culling rate (work oxen) - 0 16 16 16 16 16 16 Bulls/breeding femalesd - Carrying capacity (per hectare; end of year)a 1.2 1.6 2.1 2.5 2.5 2.5 2.5 2.5 Source: Same as table 4-4 (annex 1, table 18). See computations in table 4-27. a. In animal units. The carrying capacity at the beginning of the year is determined by multiplying the animal units per farm at the end of the previous year (given in table 4-10) by the 100 farms in the model. The carrying capacity per hectare at the end of the year is determined by dividing the animal units per farm by the 10.5 hectares of pasture on each farm; it is thus a weighted average of natural and improved pasture. (Notes continue on the following page.) FARM INVESTMENT ANALYSIS 115 The projection can become computationally quite complicated, however, for larger animals fed mainly pasture, such as sheep or cattle used for dairy or beef production. The project analyst often relies on the livestock technician for these projections and simply incorporates them into his farm investment analysis. But livestock technicians themselves may be unfamiliar with the details of how to make these computations- and especially with how to make them so they conform to the accounting convention adopted here for the farm investment analysis. For this reason, the computation for the herd projection in the Paraguay example is discussed in considerable detail in the appendix to this chapter (where definitions of the specialized livestock terms may also be found). This methodology can be adapted, with only minor variations, to projections for dairy animals. As in the treatment here, the details of the projection need not form part of the main body of most project reports; only a summary need be given (as in table 4-11 from the Paraguay example), with the details laid out in an annex or in the project file. Projecting the herd composition on a small farm when larger animals are to be produced introduces the difficult problems of divisibility. As noted, herd projections for animals that are mainly grazed on pasture are based on the estimated feed availability. Technical coefficients, such as mortality and calving rates, are often directly influenced by the amount of available feed, but in cattle production changes do not happen im- mediately. For example, an increase in feed availability in one season will improve the calving rate and decrease calf losses only during the next season. The projected coefficients are applied to the herd at the beginning of the project. The result begins to appear in the herd composition at the beginning of year 2. Often, the projected coefficients indicate that the herd's composition and its overall size will not change fast enough to utilize the increased feed available. As a solution, in-calf heifers can be purchased to increase the reproductive component of the herd, or feeder steers can be purchased for fattening until the herd can utilize the forage resources. This use of technical coefficients raises few problems of interpretation for larger farms or ranches with herds of 100 or more animals. For small farms, however, the technical coefficients lead to many "fractional ani- mals." In the Paraguay example, for instance, at full development from years 7 through 20 the farm is expected to have eight breeding cows. The adult mortality is expected to be 2 percent, so do we report that 0.16 cows die each year (8 x 0.02 = 0.16)? Such nonsensical results have led project b. Herd productivity is the sum of the off-take rate and the herd growth rate. Only the values for a stable herd are given. c. Represents a weighted average between the calving rate of breeding cows in the existing herd, which is 70 percent, and that of purchased in-calf heifers, which is nearly 100 percent. d. Note that in this project a minimum of one bull per farm is assumed, or a minimum of 100 bulls on 100 farms. Normally the number of bulls per 100 breeding females would be three or four for all years. 116 FINANCIAL ASPECTS OF PROJECT ANALYSIS analysts to seek means to overcome the divisibility problem. Some have simply ignored technical coefficients, such as mortality, that result in very small, fractional animal figures. This omission, however, consider- ably distorts the pattern farm investment analysis. To avoid such distor- tion, other analysts have devised systems that carry fractional animals in the computation until the fractions add up to a whole animal, which is then reported. In the Paraguay example, for instance, the calving rate at full development is 75 percent. Thus, six calves are born, of which half may be expected to be female. Calf mortality is 5 percent, and this gives a figure of 2.8 to be carried over to the next year as heifers 1-2 years old [8 x 0.75 + 2 - (8 x 0.75 - 2 x 0.05) = 2.8]. Of these, 2 percent are reported and 0.8 is carried over to the following year, which then will show a figure of 3.6 (0.8 + 2.8 = 3.6). Of these, 3 are reported and 0.6 is carried forward, and so forth. Mortality may sometimes be treated by incorporating a more formal probability assumption. Such systems become quite complex and in the end do not satisfactorily project an individual small herd. Another approach that is increasingly used-and that is adopted and recom- mended here-is to do the herd projection for a number of farms, say 100, that will contain or eliminate the divisibility problem. Purchases and sales are then valued, and only the values are entered in the farm invest- ment analysis for a single pattern farm. In effect, this says that on the average a farm will have a certain level of purchases and sales. This, too, is not a fully satisfactory convention. Its results do not state, for example, how many animals are actually on the farm at any given time. It does have the virtue, however, of being simpler than other systems-even if it is still quite complex-and of generating somewhat less distortion. Project designers may want to introduce an insurance scheme to pro- tect project participants from, say, the loss of a bull. Then, in effect, the values in the farm investment analysis for a single farm for the purchase of bulls include an insurance premium that insures that the farmer will be reimbursed in the event of the death of a bull. Such insurance schemes are found in developing countries, but they give rise to possibilities of abuse and to difficult administrative problems, and they often are not very effective. In the Paraguay example summarized in table 4-11, the herd composi- tion is given for each major class of animals without the project and for each project year. (The table is drawn from the worksheet reproduced in table 4-27.) Note that the analyst assumed that each farm would have a bull, so that the number of bulls remains 100, many more than would be needed if the analysis were, indeed, for a single herd rather than for 100 small farms. Note, also, the purchase of draft animals at the end of the first year. It is assumed that each farm will purchase two work oxen. The total animal units for the herd are shown, and for convenience this figure is compared with the carrying capacity. As noted in the appendix to this chapter, the number of breeding cows has been rounded to an even multiple of the number of farms in the model so that each farm has five breeding cows without the project and increases its herd to eight breed- FARM INVESTMENT ANALYSIS 117 ing cows at full development. As a result, the total of animal units does not very closely approximate the carrying capacity. Since estimates of carrying capacity are quite approximate, however, overstocking of up to 10 percent would probably be acceptable. Purchases of each class of animal are treated next in the investment analysis; these will form the basis for the investment and operating expenditure for the livestock aspect of the 20-hectare mixed farm. The sales give the basis for the inflow for the farm. The herd productivity, a measure of the efficiency of the herd, is also given; it relates the number of head sold plus the increase in herd size to the number of head carried at the beginning of the year. Only the figures for the stable herd without the project and at full development are given. The dynamics of herd growth tend to distort the measure during the period when the herd is increasing in size. (The details of the computation are given in table 4-28.) Finally, the technical coefficients for the herd are given. These are crucial parameters of the herd growth and are indicators of management effectiveness, animal health care, and feed availability. When feed concentrates are important in the farm production pattern, it may be desirable to project the feed requirements the livestock activity will involve. (An illustrative example is included in tables 4-29 and 4-30 in the appendix to this chapter in connection with the discussion of herd projections.) In some instances it may be desirable to report yield per animal if the valuation system is based, say, on kilograms. In the Paraguay example the prices are based on individual animals without regard to weight, so yield per animal is not needed and is therefore not illustrated. VALUATION. To begin the valuation of the farm production, the farm- gate prices for items entering the farm investment analysis are listed as shown in table 4-12. (The symbol for Paraguayan guaranis is 0.) If a farm-gate price is used in only one table of the investment analysis, it may not be included in the farm-gate price table but may appear in the appropriate table. (Such is the case, for example, of the prices for land improvement, which are included in table 4-15, devoted to investment, and not in the table of farm-gate prices.) Some farm-gate prices were collected and projected by the project analyst on the basis of field observation. Other prices were collected in the field but forecast using the projections of the World Bank. Prices and their derivation were discussed in more detail in chapter 3. The value of production for the farm is given in table 4-13. For crops, values are determined by multiplying the production in table 4-10 by the price per ton in table 4-12. For livestock, the value is obtained by multi- plying sales from table 4-11 by the price per animal given in table 4-12. The product is then divided by 100 to give the value for a single farm, in line with the convention recommended to avoid the divisibility problem. INCREMENTAL RESIDUAL VALUE. In the last year of the farm investment analysis, the incremental residual (or terminal) value on the farm is 118 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 4-12. Farm-Gate Prices, 20-Hectare Mixed Farm, Paraguay Project (thousands of 0) Project year Itema 1 2 3-5 6-20 Farm labor (per work day) 0.3 0.3 0.3 0.3 Crops (per ton) Maize 12.0 12.0 12.0 12.0 Manioc 3.0 3.0 3.0 3.0 Beans 28.0 28.0 28.0 28.0 Cotton 44.4 45.1 45.1 44.9 Soybeans 23.6 20.9 26.2 28.9 Sunflower 20.0 20.0 20.0 20.0 Livestock (per head) Bulls 30.0 30.0 32.4 33.6 Culled bulls 23.0 23.0 24.8 25.8 Breeding cows 18.7 18.7 20.2 20.9 Culled cows 17.0 17.0 18.4 19.0 Heifers 1-2 years 12.5 12.5 13.5 14.0 Heifers 2-3 years 18.7 18.7 20.2 20.9 Culled heifers 2-3 years 17.0 17.0 18.4 19.0 Steers 1-2 years 12.5 12.5 13.5 14.0 Steers 2-3 years 18.7 18.7 20.2 20.9 Steers 3-4 years 23.0 23.0 24.8 25.8 Work oxen 35.0 35.0 37.8 39.2 Culled work oxen 23.0 23.0 24.8 25.8 0 Paraguayan guaranis. Source: Same as table 4-4. a. Prices of maize, soybeans, and livestock are adjusted for the real price changes projected by the Commodities and Export Projections division of the World Bank. Other prices are assumed to remain constant in real terms. included among the inflows in the farm budget and "credited" to the project investment. This is done because not all the utility of an invest- ment may be exhausted in the course of a project. Note that it is the incremental value that is sought, not the total value. In some instances there is no distinction, since the value of an item such as construction may be entirely incremental. But for items such as land, livestock, and working capital, there may have been values existing at the beginning of the project, and only the incremental residual value may properly be credited to the project investment. Since the incremental residual value enters the farm investment analysis in the final year, it bears relatively little weight in the discounting process. As a result, rather broad esti- mates of residual values are acceptable in project analysis. Three kinds of residual value may be noted. The first is the salvage value of capital assets that have been largely consumed by the end of the project and that, for the most part, can only be salvaged for their scrap value or have only a short portion of their normal life expectancy remain- ing at the end of the project period. Buildings and other construction or machinery such as irrigation pumps or tractors are common examples. A second kind of residual value is the working capital. This is automati- FARM INVESTMENT ANALYSIS 119 cally allowed for under the accounting convention we have adopted for the farm investment analysis. The third kind of residual value is the value of items that have a substantial useful life remaining at the end of the project and may even have increased in value as a result of the project investment; land with associated improvements and a livestock herd are examples. All three kinds of residual value are illustrated for the Paraguay exam- ple in table 4-14. In a land improvement project such as this one, there usually would be an entry for the incremental value of land, although in this instance the analyst chose not to include it because the site in Paraguay is a frontier area and the land market is not very active. In more crowded societies where a project involves land improvement such as better irrigation and drainage, the incremental value of the land might be quite substantial. Next for consideration would be the incremental residual value of construction. In the Paraguay example, the construction is all incremental, so the incremental residual value is quite simply obtained by taking a proportion of the initial construction, in this case 10 percent. The incremental residual value of equipment is assumed to be negligible, although that would not necessarily be the case in other projects. Then the analyst considers the incremental value of livestock. In this case, care must be taken to distinguish between the total residual value of the livestock herd and the incremental residual value. There was, of course, a livestock herd at the beginning of the project, so only the increased value of the herd at the end of the project can be attributed to the project investment itself. Hence, each class of animals is valued at the beginning of the project and at the end of the project, and only the difference-or increment-is carried forward as the incremental re- sidual value. Finally, there is the total incremental working capital. The reader will recall that, in the discussion of the accounting convention for farm investment analysis, considerable attention was devoted to esti- mating the incremental working capital year by year. Once this is done, all that is needed to obtain the total incremental working capital is simply to add the incremental working capital for each year algebra- ically-that is, adding the increases and subtracting decreases-to obtain the incremental residual value entered in the final year. Farm inputs When the estimates of production are complete, the estimates of the necessary inputs may be prepared. Inputs comprise the investment, operating expenditure, and incremental working capital for the project. INVESTMENT. Investment for the project is a crucial element. The in- vestment contemplated for the Paraguay pattern farm is given in table 4-15. It is convenient to show the unit and unit cost in the investment table; for convenience, items appearing only in the investment table may be omitted from the farm-gate price table. As in this presentation, the total physical investment may be incorporated in the investment cost Table 4-13. Value of Production, 20-Hectare Mixed Farm, Paraguay Project (thousands of G) Without project With project Item Year 1 2 3-5 6-20 1 2 3 4 5 6 7-20 Cropsa Maize 7.2 7.2 7.2 7.2 7.2 7.2 7.2 7.2 7.2 7.2 8.4 Manioc 54.0 54.0 54.0 54.0 54.0 54.0 60.0 30.0 33.0 33.0 36.0 Beans 11.2 11.2 11.2 11.2 11.2 11.2 14.0 14.0 14.0 - - Cotton 115.4 117.3 117.3 116.7 115.4 135.3 135.3 157.8 180.4 229.0 229.0 Soybeans - - - - - 29.3 36.7 91.7 104.8 156.1 156.1 Sunflower - - - - - - 36.0 40.0 48.0 60.0 72.0 Total 187.8 189.7 189.7 189.1 187.8 237.0 289.2 3407 387.4 485.3 501.5 Livestockb Culled bulls 3.4 3.4 3.7 3 9 6.9 3.9 4.5 4.5 4.5 4.6 4.6 Culled cows 10.2 10.2 11.0 11.4 10.2 16.7 22.1 20.6 20.6 21.3 21.3 Culled heifers 1.4 1.4 1.5 1.5 1.4 2.6 2.8 4.0 5.3 5.3 5.3 Surplus heifers 12.0 12.0 12.9 13.4 0 0 0 12.7 25.2 24.5 24.5 Steers 3-4 years 32.9 32.9 35.5 36.9 32.9 32.9 35.7 36.2 51.8 71.2 69.1 Culled work oxen - - - - - 7.4 7.9 7.9 7.9 8.3 8.3 Total 59.9 59.9 64.6 67.1 51.4 63.5 73.0 85.9 115.3 135.2 133.1 Total value 247 7 249.6 254.3 256.2 239.2 300.5 362.2 426 6 502.7 620.5 634.6 Source: Calculated from tables 4-10, 4-11, and 4-12. b. Sales from table 4-11 multiplied by the price per animal from table 4-12; a. Production from table 4-10 multiplied by the price per ton from table product is then divided by 100 to give the value for a single farm. See text for a 4-12. For year 2 without the project, for example, the value of cotton is the discussion of this convention. without-project production from table 4-10 times the price in year 2 in table 4-12. FARM INVESTMENT ANALYSIS 121 Table 4-14. Incremental Residual Value, 20-Hectare Mixed Farm, Paraguay Project (thousands of 0) Value At beginning At end Incre- Item of project of project mental Land a a a Constructionb 0 18.0 18.0 Equipmentc 0 0 0 Livestockd Bulls 30.0 33.6 Breeding cows 93.5 167.2 Heifers 1-2 years 19.6 39.9 Heifers 2-3 years 28.4 58.3 Steers 1-2 years 19.6 39.9 Steers 2-3 years 28.4 58.3 Steers 3-4 years 33.8 70.4 Work oxen - 78.4 Total 253.3 546.0 292.7 Working capitale - - 119.9 Total 430.6 Source: Calculated from other tables as noted. a. In the Paraguay example, the analyst chose not to include an incremental value of land improvements in his computation of residual value. This amount usually is included if there has been substantial land improvement. b. The residual value of construction is taken as 10 percent of the total construction investment given in table 4-15. c. The residual value of equipment is assumed to be negligible. Only equipment pur- chased for the project is included in the computation, not the equipment existing on the farm at the beginning of the project. d. The value of the livestock at the beginning of the project is calculated from the herd composition at the beginning of the year in table 4-11 multiplied by the year-I prices in table 4-12. The value of the livestock at the end of the project is calculated from the year-20 herd composition in table 4-11 multiplied by the year-20 prices in table 4-12. e. From table 4-17. table; in other instances, a separate table may be needed. Although it is not shown for the Paraguay example, including the foreign exchange component of the investment cost is often desirable. It is important that an agricultural project report detail the foreign exchange needed for the project because the availability of foreign exchange may be a major constraint. Investment for the Paraguay example is divided into land improvement, construction, equipment, and livestock, the major categories likely to be found in an agricultural project. Within each category the major items are noted, and the investment for them is tabulated by project year. The total investment by year and for the pattern as a whole is given. Note how the analyst accommodated the existing equipment found on project farms in this pattern by listing equipment totaling 0206 thousand, but then subtracting 050 thousand as an average of existing equipment. For livestock, it is assumed that all heifer purchases and culling in excess of that normally done without the project are an investment. 122 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 4-15. Investment, 20-Hectare Mixed Farm, Paraguay Project (thousands of 0) Project year Unit Itema cost 1 2 3 Total Land improvement (per hectare) Clear, cut and burn forestb 15.0 52.5 52.5 52.5 157.5 Destumping' 20.0 100.0 0 40.0 140.0 Pasture establishmentd 1.0 3.5 3.5 3.5 10.5 Total 156.0 56.0 96.0 308.0 Construction (per single unit) Storage 40.0 40.0 0 0 40.0 Welle 50.0 50.0 0 0 50.0 Fencing wire (for 1 ha) 8.6 30.1 30.1 30.1 90.3 Total 120.1 30.1 30.1 180.3 Equipment (per single unit) Plow 18.0 18.0 0 0 18.0 Disc harrow 65.0 65.0 0 0 65.0 Seeder 30.0 30.0 0 0 30.0 Cultivator 17.0 17.0 0 0 17.0 Ox cart 50.0 50.0 0 0 50.0 Sprayer 11.0 11.0 0 0 11.0 Hand tools 15.0 15.0 0 0 15.0 Subtotal 206.0 0 0 206.0 Less existing equipmentf ( 50.0) 0 0 ( 50.0) Total 156.0 0 0 156.0 Livestock (per head)9 Heifers 2-3 yearsb - 17.0 24.5 0.4 41.9 Bulls' 30.0 4.5 0 0 4.5 Work oxenJ 35.0 70.0 0 0 70.0 Total 91.5 24.5 0.4 116.4 Total investment 523.6 110.6 126.5 760.7 Note: Parentheses indicate negative numbers. Source: Same as table 4-4 (annex 1, table 16). a. Family labor is valued at its opportunity cost (see the discussion of the farm budget). The number of work days required is given in table 4-7. b. Clearing is done by a contractor. It is assumed that forest will be cleared to establish improved pasture and that clearing proceeds at the pace given for incremental improved pasture in table 4-4. c Destumping is done by a contractor. Following the land use given in table 4-4, it is assumed that 5 hectares, consisting of the 4 hectares of existing cropland plus the addi- tional hectare to be cultivated in year 2, will be destumped in year I and the remaining 2 hectares in year 3. d. The cost of pasture establishment includes only the purchase of colonial variety grass (Panicum maximum). e. An open well of 20 meters at 02.5 thousand a meter. f. It is assumed that, of the equipment listed, farmers will already own items of a total value amounting to (50 thousand (in parentheses) g. From the purchases in table 4-11 multiplied by the prices in table 4-12, the product then divided by 100 to give the value for a single farm. See text for a discussion of this convention. Normal replacement of death loss and culls is considered an operating cost. h. All heifer purchases are considered investment. The prices are taken from table 4-12. i. The excess over normal death loss and without-project culling for bulls in year I is considered investment. For the 100-farm herd, table 4-27 shows 33 replacement bulls will FARM INVESTMENT ANALYSIS 123 Thus, the heifers purchased are included in the investment tabulation, as are the excess bulls culled in year 1. The work oxen purchased in year 1 are clearly an investment. In years 2 through 20, oxen purchased are to replace animals lost through death and culling; thus, these purchases are considered as operating expenditure. The amounts for the livestock in- vestment are obtained by taking the numbers of animals given in table 4-11, multiplying by the prices in table 4-12, and then dividing by 100 to obtain the amount from a single farm. This is in line with the convention recommended in the discussion of the herd composition, purchases, and sales. (The sale of replaced livestock, such as indigenous cows sold be- cause improved cows are purchased, is better treated as a "negative investment" and not as a benefit.) In the investment cost tabulation, allowance would be made for any hired labor used for investment purposes. In the Paraguay example, none is used because the clearing and destumping are assumed to be done by contractors. No allowance is made for family labor devoted to invest- ment. This is because the farm family is the recipient of the incremental net benefit as shown in the farm budget. Thus, the family remuneration is the net income stream. Including it under investment cost would consti- tute double counting. Note, however, that the family does contribute some investment in the Paraguayan example. The fencing and pasture establishment, for instance, are done by family labor. The demand for family labor for investment is accounted for under the labor requirement in tables 4-6 and 4-7. OPERATING EXPENDITURE. The operating expenditure is given for crops, livestock, and equipment for the Paraguay pattern farm in table 4-16. (The term "expenditure," rather than the more common "cost," is used here because operating cost implies an element of depreciation not included when the farm investment analysis is laid out in accord with the princi- ples of discounted cash flow analysis.) Although unit expenditure per hectare is given in the table, it could have been tabulated instead from the farm-gate prices in table 4-12 on a price-per-unit basis, with the amounts needed for a hectare listed in the table for operating expendi- ture. This would have been less convenient but more revealing. For livestock, replacement of normal death loss and without-project culling are considered operating expenditures. As with the investment cost, they are obtained by taking the purchases from table 4-11, multi- plying by the farm-gate prices in table 4-12, then dividing by 100 to obtain the value for a single farm. The operating expenditure for miner- als, vaccines, and the like is based on the animal units in the herd at the beginning of the year. The cost of pasture maintenance is estimated on be purchased in year 1. Of these, 3 are to replace death loss, and 15 represent the normal culling as practiced without the project. The additional 15 bulls culled in year 1 are considered investment. Their value is divided by 100 to give the value for a single farm of 04.5 thousand {[(33 - 3 - 15) x 30] 100= 4.51. j. Work oxen purchased in year I are considered investment. Table 4-16. Operating Expenditure, 20-Hectare Mixed Farm, Paraguay Project (thousands of G) Expenditure Without project With project Product per and operationa hectare Year 1-2 3-5 6-20 1 2 3 4 5 6 7-20 Crops Maizeb 0 0 0 0 0 0 0 0 0 0 0 Maniocb 0 0 0 0 0 0 0 0 0 0 0 Beansb 0 0 0 0 0 0 0 0 0 0 0 Cotton Hired labor' - 0 0 0 0 0 0 4.5 8.1 16.8 17.4 Seedd 0.8 1.6 1.6 1.6 1.6 1.6 1.6 1.8 2.0 2.4 2.4 Pesticidesd 4.6 9.2 9.2 9 2 9.2 9.2 9.2 10.1 11.5 13.8 13.8 Total cotton 10.8 10.8 10.8 10.8 10.8 10.8 16.4 21.6 33.0 33.6 Soybeans Hired labor' - - - - - 0 0 2.1 4.5 9.3 9.6 Seed" 2.8 - - - - 2.8 2.8 6.2 7.0 8.4 8.4 Pesticidesd 1.5 - - - - 1.5 1.5 3.3 3.8 4.5 4.5 Fertilizer" 8.0 - - - - 8.0 8.0 17.6 20.0 24.0 24.0 Threshinge - - - - - 2.8 2.8 7.0 8.0 10.8 10.8 Total soybeans - - - - 15.1 15.1 36.2 43.3 57.0 57.3 Sunflower Hired labor' - - - - - 0 0 0 0.3 0.6 1.2 Seedd 0.6 - - - - 1.2 1.2 1.3 1.5 1.8 1.8 Pesticidesd 1 2 - - - - 2.4 2.4 2.6 3.0 3.6 3.6 Threshing' - - - - - 0 3.6 4.0 4.8 6.0 7.2 Total sunflower - - - - 3.6 7.2 7.9 9.6 12.0 13.8 Total crops 10.8 10.8 10.8 10.8 29.5 33.1 60.5 74.5 102.0 104.7 Livestock Minerals, vaccines, etc. - 6.8 6.8 6.8 6.8 8.6 10.0 11.4 12.3 12.6 12.5 Improved pastureg 1.0 - - - 0 3.5 7.0 10.5 10.5 10.5 10.5 Replacement purchasesh Bulls' - 5.4 5.8 6.0 5.4 6.0 6.5 6.5 6.5 6.7 6.7 Work oxen' - - - - 0 13.3 13.6 13.6 13.6 14.1 14.1 Total livestock 12.2 12.6 12.8 12.2 31.4 37.1 42.0 42.9 43.9 43.8 Equipment Operation and maintenancek - 2.5 2.5 2.5 2.5 10.3 10.3 10.3 10.3 10.3 10.3 Total equipment 2.5 2.5 2.5 2.5 10.3 10.3 10.3 10.3 10.3 10.3 Total operating expenditure 25.5 25.9 26.1 25.5 71.2 80.5 112.8 127.7 156.2 158.8 Source: Calculated from other tables as noted. i. The normal death loss and without-project culling for bulls in year I is a. Family labor is valued at its opportunity cost (see the discussion of the considered operating expenditure. For the 100-farm herd, table 4-27 shows farm budget). The number of work days required is given in table 4-7. that 33 replacement bulls will be purchased in year 1. Of these, 3 are to replace b. Assumes no cash expenditure needed for production. death loss, and 15 represent the normal culling as practiced without the c. From table 4-8 multiplied by the 0300 a day shown in table 4-12. For project, so all may be considered an operating expenditure. The value of the 18 sunflower, table 4-8 allocates labor according to the labor requirement in replacement animals is divided by 100 to give the value for a single farm of table 4-7 for the year of planting. See note c in table 4-7. 05.4 thousand (18 x 30 - 100 = 5.4). The additional 15 bulls culled in year 1 d. From the areas in table 4-4 times the unit cost given. For sunflower, seed are considered investment. For years 2 through 20, all bull purchases are and pesticide costs are based on the year of planting. considered replacements and thus operating expenditure. e. From production in table 4-10 multiplied by a threshing cost of 02 j. Work oxen purchased to replace death loss and culls from years 2 through thousand per ton. 20 are considered operating expenditure. Work oxen purchased in year 1 are f. At q,500 an animal unit multiplied by the animal units of herd pasture considered investment. requirement in table 4-11 at the beginning of the year, the product then k. Operation and maintenance cost of equipment is taken to be 5 percent of divided by 100 to give the value for a single farm. the investment cost beginning the year after acquisition. It is assumed that g. Maintenance; calculated on the basis of improved pasture established in without the project the farm has 050 thousand of equipment and thus an previous years as shown in table 4-4. annual equipment, operation, and maintenance expense of 02.5 thousand (50 h. From the purchases in table 4-11 multiplied by the prices in table 4-12, x 0.05 = 2.5). With the project, this expense continues, plus the maintenance the product then divided by 100 to give the value for a single farm. See text for of the incremental 0 156 thousand worth of equipment purchased in year 1 as a discussion of this convention. Normal replacement of death loss and culls is shown in table 4-15, giving a total of 010.3 thousand [2.5 + (156 X 0.05) considered an operating cost. 10.3]. 126 FINANCIAL ASPECTS OF PROJECT ANALYSIS the basis of improved pasture established as of the end of the previous year. Expenditure for operation and maintenance of equipment is taken to be 5 percent of the initial investment cost beginning the year after acquisition. Expenditure for operation and maintenance of equipment, such as that for pumps, is often included in the operating expenditure of the crop for which the equipment is used. When it is not, as in this example, then it must be shown separately. The operating expenditure does not include a separate entry for family labor or for land. Rather, these are valued at their opportunity cost by the approach taken in designing the farm budget. (Opportunity cost was defined early in chapter 3, in the section "Prices Reflect Value.") We will return to a discussion of how this is accomplished after we have dis- cussed the farm budget, below. INCREMENTAL WORKING CAPITAL. The incremental working capital for the Paraguay pattern farm is given in table 4-17. As noted in the discussion of the accounting convention adopted for farm investment analysis and in table 4-3, the incremental working capital is derived from the informa- tion on total operating expenditure in table 4-16 by taking some proportion of the incremental operating expenditure for the following year. To sim- plify the calculation, it is assumed that the Paraguay pattern farm is predominantly a one-season, annual crop farm. Referring to table 4-3, we note the incremental working capital as a percentage of incremental operating expenditure for one season annual crops ranges between 80 and 100 percent. The incremental working capital needed, then, may be taken at the midpoint of the range, or 90 percent of the incremental operating expenditure in the following year. In year 2, for example, the Table 4-17. Incremental Working Capital, 20-Hectare Mixed Farm, Paraguay Project (thousands of 0) Project year Item 1 2 3 4 5 6 7 8-20 Total Total operating expenditurea 25.5 71.2 80.5 112.8 127.7 156.2 158.8 158.8 - Incremental operating expenditure - 45.7 9.3 32.3 14.9 28.5 2.6 0 133.3 Incremental working capitalb 41.1 8.4 29.1 13.4 25.6 2.3 0 0 119.9 Source: Calculated from tables 4-3 and 4-16. a. From table 4-16. b. Taken to be 90 percent of the incremental operating expenditure in the following year. For year 1, for example, this comes to 041.1 thousand [(71 - 25.2) x 0.9 = 41.1]. This is based on the recommendatioh that incremental working capital be a percentage of in- cremental operating expenditure as given in table 4-3. For purposes of this calculation, it is taken that the model farm is dominantly a one-season, annual crop farm, even though there is a second crop of sunflower and there is a livestock enterprise. Accepting this assumption somewhat overstates the incremental working capital needed. FARM INVESTMENT ANALYSIS 127 incremental operating expenditure is 045.7 thousand (71.2 - 25.5 = 45.7) and the incremental working capital in year 1, which is 90 percent of the incremental operating expenditure in the following year, is thus 041.1 thousand (45.7 x 0.9 = 41.1). This simplification somewhat overstates the working capital needed. Note that by totaling the in- cremental working capital year by year we obtain the 0 119.9 thousand residual incremental working capital shown in table 4-14. Had we wished to make a more precise estimate of the incremental working capital, we could have calculated the amount needed for each category of operating expenditure as given in table 4-16. For crops, we could have taken from table 4-3 the same 90 percent estimate we accepted in our simplification. Taking year 5 as an illustration, the incremental working capital for crops would have been 024.8 thousand [(102.0 - 74.5) x 0.9 = 24.8]. For livestock, we might have accepted 30 percent from the recommended range of 20 to 40 percent in table 4-3. Since the without-project working capital will also increase during the life of the project, the computation of the incremental working capital is somewhat more complicated for livestock than for crops. The without- project incremental operating expenditure must be subtracted from the with-project incremental operating expenditure. This is a minor adjust- ment and might have been ignored. Taking year 5 as an illustration again, the incremental working capital for livestock would be 00.2 thousand {[(43.9 - 42.9) - (12.8 - 12.6)] x 0.3 = 0.2}. For equipment, we would have taken the full incremental operating expenditure; this, however, does not increase between years 5 and 6 and so is zero (10.3 - 10.3 = 0). Adding the combined incremental working capital for all three categories, we reach an incremental working capital for the farm in year 5 of Q25.0 thousand (24.8 + 0.2 + 0 = 25.0). This compares with the estimate of incremental working capital of 025.6 thousand that our simplified calculation in table 4-17 gave us for year 5. Farm budget With the pattern farm resource use, production, and inputs known, the analyst may proceed to draw up the farm budget. When a farm budget for project analysis is prepared, the objective is an estimate of the incremental net benefit arising on the farm as a result of the project. Clear layout of the incremental net benefit is the main reason for the particular format adopted here and illustrated in tables 4-18 through 4-20 for the farm budget of the Paraguay project. The analyst first calculates the net benefit without the project as shown in table 4-18. The overall format of the pattern farm budget can be seen in the with-project farm budget shown in table 4-19. If we take the inflow received on the farm year by year and subtract the outflow, we have the stream for net benefit before financing. This entry tells what the farm will earn without consideration of any effects of financing. It includes both the value of the crop and livestock production sold off the farm and the value of home-consumed production. Next we subtract the without- 128 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 4-18. Without-Project Farm Budget, 20-Hectare Mixed Farm, Paraguay Project (thousands of 0) Project year Item 1 2 3-5 6-20 Inflow Gross value of production' 247.7 249.6 254.3 256 2 Total 247.7 249.6 254.3 256.2 Outflow Operating expenditureb 25.5 25.5 25.9 26.1 Other Tax on cattle salec 2.3 2.3 2.3 2.3 Total 27.8 27.8 28.2 28.4 Net benefit before financingd 219.9 221.8 226.1 227.8 Source: Calculated from other tables as noted. a. From table 4-13. b. From table 4-16. c. A tax of Q800 is paid on each animal sold. The amount is calculated by multiplying the total sales given in table 4-11 by the tax and dividing the result by 100 to obtain the amount for each farm. d. No financing would be received without the project. project net benefit (table 4-18) to obtain the incremental net benefit before financing. In many projects, the without-project incremental net benefit is assumed to remain constant throughout the life of the project, and a without-project column is inserted before the columns for the project years. This constant without-project amount is then subtracted from the net benefit before financing in each project year to obtain the incremental net benefit before financing. In the Paraguay example, the without-project net benefit before financing changes during the life of the project, so this approach cannot be used. Instead, a separate figure for without-project net benefit before financing is calculated as shown in table 4-18; this figure has been entered in the with-project farm budget in table 4-19. Note that in the early years of the with-project farm budget the in- cremental net benefit before financing will generally be negative as investment is undertaken. Later, when the stream turns positive, it is a measurement of the additional amount that the farm will produce as a result of the project. The stream of the incremental net benefit before financing is the cash flow as defined in chapter 9. When it is discounted, again as discussed in chapter 9, it becomes the basis for such measure- ments of project worth as the net present worth ofall resources engaged, the financial rate ofreturn to all resources engaged, or the net benefit-investment ratio of all resources engaged. Deriving measurements of project worth based on all resources engaged, whether the resources come from the farmer's own contribution or a lending institution, is commonly done to FARM INVESTMENT ANALYSIS 129 judge the financial viability of the investment on the farm. It is especially favored by analysts who have accounting experience. If we eliminate transfer payments and value entries at efficiency prices as discussed in chapter 7, the incremental net benefit before financing is the incremental contribution to the national income. Aggregated to the project level, it becomes the basis for the benefit stream for the project and for calculating the net present worth, the economic rate of return, or the net benefit-investment ratio for the project-that is, the return which the project contributes to the economy as a whole. If we proceed to look at the financing available with the project-after we allow for loan receipts and debt service including interest payments and repayment of principal, which together give the net financing-we reach the net benefit after financing. This is also called the farm family net benefit, since it is the amount that the family has to live on for the year. Maximizing the net benefit after financing is taken to be the objective of the farm family; it is thus defined consistently with the objectives laid out in chapter 2. This is a most important estimate because, obviously, it directly affects the incentive to the farm family to participate in the project. The difference between what the family would receive without the project and the net benefit after financing is the incremental net benefit after financing. This is the additional amount the family would receive by participating in the proposed project over and above what it would receive without the project. Note that, as in the Paraguayan example, the incremental net benefit generally will be negative in the first few years if the farmer must invest some of his own resources to participate in the project. The incremental net benefit (or incremental farm family net benefit) is, in effect, the direct incentive to the family to participate in the project. It is the cash flow seen from the point of view of the farmer, as defined in chapter 9. Discounted, it will give the financial rate of return to the farmer's own resources if he has invested any of his own capital in the project. Discounting the net benefit after financing and dividing by the discounted net benefit after financing without the project yields the net benefit increase, a measure of farmer incentive discussed in more detail in the section devoted to that topic later in this chapter. It is extremely convenient to separate the financing transactions in the farm budget, as is illustrated in the Paraguay example. By leaving financ- ing to a later part of the table, we can concentrate on what the farm will produce in arriving at the incremental net benefit before financing. This gives a direct estimate of how much total investment will be needed from all sources for the pattern farm. The incremental net benefit before financing is derived directly, and this makes it convenient to calculate the measures of project worth based on all resources engaged. This format directly provides a basis for aggregation and is also the starting point for the economic analysis discussed in chapter 7. Grouping the financing transactions is convenient if there is a credit element in the project, as there so often is, because it permits looking at the credit Table 4-19. Farm Budget, 20-Hectare Mixed Farm, Paraguay Project (thousands of 0) Project year Item 1 2 3 4 5 6 7 8-11 12 13 14-19 20 Inflow Gross value of production" Crops 187.8 237.0 289.2 340.7 387.4 485.3 501.5 501.5 501.5 501.5 501.5 501.5 Livestock 51.4 63.5 73.0 85.9 115.3 135.2 133.1 133.1 133.1 133.1 133.1 133.1 Off-farm income - - - - - - - - - - - - Incremental residual valueb - - - - - - - - - - 430.6 Total inflow 239.2 300.5 362.2 426.6 502.7 620.5 634.6 634.6 634.6 634.6 634.6 1,065.2 Outflow Investment' 523.6 110.6 126.5 0 0 0 0 0 0 0 0 0 Incremental working capitald 41.1 8.4 29.1 13.4 25.6 2.3 0 0 0 0 0 0 Operating expenditure' 25.5 71.2 80.5 112.8 127.7 156.2 158.8 158.8 158.8 158.8 158.8 158.8 Other Tax on cattle salef 1.9 2.4 2.6 3.1 4.2 4.7 4.6 4.6 4.6 4.6 4.6 4.6 Total outflow 592.1 192.6 238.7 129.3 157.5 163.2 163.4 163.4 163.4 163.4 163.4 163.4 Net benefit before financing Total (352.9) 107.9 123.5 297.3 345.2 457.3 471.2 471.2 471.2 471.2 471.2 901.8 Without project8 219.9 221.8 226.1 226.1 226.1 227.8 227.8 227.8 227.8 227.8 227.8 227.8 Incremental (572.8) (113.9) (102.6) 71.2 119.1 229.5 243.4 243.4 243.4 243.4 243.4 674.0 Financingh Loan receipts 508.2 107.1 140.0 0 0 0 0 0 0 0 0 0 Debt service - 66.1 80.0 98.2 98.2 159.2 172.1 188.9 61.8 35.0 0 0 Net financing 508.2 41.0 60.0 ( 98.2) ( 98.2) (159.2) (172.1) (188.9) ( 61.8) ( 35.0) 0 0 Net benefit after financing Total 155.3 148.9 183.5 199.1 247.0 298.1 299.1 282.3 409.4 436.2 471.2 901.8 Without project9 219.9 221.8 226.1 226.1 226.1 227.8 227.8 227.8 227.8 227.8 227.8 227.8 Incremental ( 64.6) ( 72.9) ( 42.6) ( 27.0) 20.9 70.3 71.3 54.5 181.6 208.4 243.4 674.0 Cash position Net benefit after financing 155.3 148.9 183.5 199.1 247.0 298.1 299.1 282.3 409.4 436.2 471.2 901.8 Less home-consumed production' 50.0 50.0 50.0 50.0 50.0 40.2 44.4 44.4 44.4 44.4 44.4 44.4 Cash surplus (or deficit) 105.3 98.9 133.5 149.1 197.0 257.9 254.7 237.9 365.0 391.8 426.8 857.4 Net present worth at 12 percent of all resources engaged = 0416 thousand' Financial rate of return to all resources engaged = 18 percent' Net benefit-investment ratio at 12 percent of all resources engaged 5 1,091.6 + 0675.4 = 1.62' Financial rate of return to the fanner's own resources = 26 percentk Net benefit increase = [(Q2,071.7 + (1,686.4) - 1] x 100 = 23 percent' Source: Calculated from other tables as noted. during which interest is paid. The loan received each year is treated as a a. From table 4-13. separate transaction. Thus, for the loan received at the end of year 1, the grace b. From table 4-14. period is for years 2 through 5 and the principal of the loan is repaid during c. From table 4-15. years 6 through 11. The interest rate is 13 percent. See table 4-24 for details of d. From table 4-17. the computation. e. From table 4-16. If labor had been hired and paid in kind and this had not i. Assumes that the family would eat all of the maize and beans and part of been included in the operating expenditure table, it would be shown here the manioc in years 1 through 5. From year 6 onward it is assumed that the under operating expenditure as a separate line. family will consume all of the maize and manioc. f. A tax of 0800 is paid on each animal sold. The amount is calculated by j. Calculated on the basis of the incremental net benefit before financing. multiplying the total sales given in table 4-11 by the tax and dividing the result For details about the method of computation, see chapter 9. by 100 to obtain the amount for each farm. k. Calculated on the basis of the incremental net benefit after financing. g. From table 4-18. No financing would be received without the project. 1. The net benefit increase is the present worth of the incremental net h. The farmer receives a loan from the Paraguayan National Development benefit after financing with the project divided by the present worth of the net Bank for 90 percent of the investment cost and for 90 percent of the in- benefit after financing without the project; expressed in percentage. See text cremental working capital during the investment period, which is years I for a discussion of this measure. For details about the method of the present through 3. The loan is for a ten-year period, with a four-year grace period worth computation, see chapter 9. 132 FINANCIAL ASPECTS OF PROJECT ANALYSIS transaction separately. The timing of the loan receipts, the timing of the debt service, and the net financing can all be determined easily by simple inspection. Then, by examining the incremental net benefit after financ- ing, an assessment can be made about the amount of credit a farmer will need to participate and when he should repay it. With the incremental net benefit after financing now available, it is a simple matter to discount it to determine the financial rate of return to the farmer's own resources. Of the individual entries included under the inflow in table 4-19, the first is the gross value of production, which is derived directly from table 4-13. This entry includes only that production available for use off the farm or by the farm family itself; it does not include any production used as an intermediate product on the farm. In particular, it does not include feed produced and fed to animals on the farm. Note the gross value of production includes any production consumed at home; it is not, there- fore, the gross sales. In the Paraguayan example, the family will consume most of the maize, manioc, and beans it produces, as noted in the last section of the farm budget. If we fail to include the value of home- consumed production as part of the gross value of production, we will understate the attractiveness to the farmer of participating in the proj- ect. Furthermore, when we recast the budget to reflect economic values we will understate the true contribution of the project to the national income. In turn, this will make the measures of project worth of those projects in which a high proportion of the incremental production is to be consumed by the farm family look relatively less attractive than those of projects in which a high proportion of the incremental production is to be sold. We may thus penalize many of the very projects that provide the greatest benefit to the most disadvantaged farmers. It is important that any off-farm income the farmer may earn be included in the budget. Hence, a dummy line has been included in table 4-19 even though there is no off-farm income involved in the Paraguay example. As we will discuss in detail in the next section, by including off-farm income in the budget we are automatically able to value family labor at its opportunity cost. This avoids trying to impute separately an appropriate wage for family labor. Two other items may enter under the inflow that were not needed in the Paraguay example. The first is direct grants received by the farmer. Subsidies that benefit the farmer by lowering the cost of an input or by increasing the price he receives for his production would not be entered here. Instead, they would be accounted for by entering the subsidized market price in the account. Later, in the economic analysis, these items would have to be revalued to reflect the subsidy. A second entry that might appear as an inflow in a farm budget but that is not needed in the Paraguay example is the rental value of the farm house. In most projects, no investment in housing is made, and the rental value remains unchanged with or without the project. As a result, the rental value has no effect on the incremental net benefit and so is gener- ally omitted. If, however, the cost of the project has included housing, as might be the case in a settlement project, then the rental value of that housing is a benefit for which allowance must be made. In most instances FARM INVESTMENT ANALYSIS 133 the rental value will be imputed and-as with all imputed values-great care must be exercised in determining it. The last of the inflow items in table 4-19 is the incremental residual value. This is derived for the Paraguayan example from table 4-14. First among the elements of the outflow is the on-farm investment. Note that the total on-farm investment is included here, not just that propor- tion the farmer is expected to pay from his own funds. The investment the farmer must make himself as of the end of the year will appear as a negative incremental net benefit after financing at the bottom of the table. For most farm investment analyses, the major items of investment would be detailed in a supporting table such as table 4-15, since the focus so often is upon some on-farm investment. In projects where the major investment is made off the farm, as might be the case in irrigation, there may be no substantial on-farm investment. The next outflow is the incremental working capital, taken from table 4-17. As noted earlier in this chapter in the discussion of the accounting convention, the incremental working capital is calculated as some pro- portion of the increase or decrease in operating expenditure the follow- ing year. It reflects, of course, the need to have on hand at the beginning of the season sufficient funds to finance inputs for crop and livestock production. The next entry for outflow is the operating expenditure, taken from table 4-16. If hired labor paid in kind were omitted from table 4-16 (which some analysts prefer to treat as a list of cash expenditures), then a separate entry would have to be included under the operating expenditure. Finally, an entry is made for other outflows. In the Paraguayan pattern farm budget, the only other outflow is for a tax on cattle sales. A tax on land, however, might also be found under this entry, as might general overhead, a betterment levy, or a capital recovery charge for an irriga- tion project. An income tax would usually not be shown here; it is uncommon for a small farmer to have to pay income tax, and, in any event, it is generally considered that income tax is levied against the farmer as an individual rather than against the farm as such. (This, of course, is in contrast to corporate income taxes, which would be shown if levied; see chapter 5 for a discussion of accounts for agricultural process- ing industries.) In general, indirect taxes such as sales taxes or tariffs on imported items will be included in the price of inputs; this works well for financial analysis, but it may lead to complications when the economic values are being estimated. The total inflow less the total outflow gives the net benefit before financing. The section of table 4-19 devoted to financing begins with the projec- tion of the loan receipts the farmer may expect if he participates in the project. Loan receipts are commonly divided into short-term and medium- or long-term. In the Paraguay example, only medium-term loans are to be received. Loans are entered in the year they are to be received. Debt service-the payment of interest and repayment of principal- follows. Usually it, too, will be disaggregated by the length of the loan maturity. Interest and principal repayments are often shown as a single 134 FINANCIAL ASPECTS OF PROJECT ANALYSIS entry, although sometimes interest payments and the principal repay- ment are shown separately. The details of how to calculate interest payments and principal repayments are discussed in the section "Com- puting Debt Service" later in this chapter. The debt service is subtracted from the loan receipts to reach the net financing, which is shown with an indication of whether it is positive or negative. In the Paraguay example, in years 1 through 3 the loan receipts exceed the debt service, so the net financing is positive; in years 4 through 13, however, debt service exceeds the loan receipts, and so the net financ- ing is negative. The net financing subtracted from (or added to, as appropriate) the net benefit before financing gives the net benefit after financing, also called the farm family net benefit. As noted, this is the amount the family has to live on with the project and is most important for judging incentive effects of the project. It is probably an estimate of this amount that most farmers make when they decide whether to participate in a project, although no doubt they arrive at it by a less formal means. If we subtract the net benefit after financing without the project from the net benefit after financing for each project year, we arrive at the incremental net benefit after financing, or incremental farm family net benefit. This is the same incremental net benefit or cash flow defined in chapter 9. It represents an undifferentiated return of and to the farmer's capital; discounted, it gives the financial rate of return to the farmer's own resources. The incremental net benefit after financing also provides us with another basis for a judgment about incentive effects. Would a farmer be willing to shoulder the additional risk and effort needed to participate in the project if he can expect this kind of incremental income? Because home-consumed production is included in the farm budget, if any high proportion of the incremental production is expected to be consumed in the farm household, it is desirable to have a section on the cash position to determine whether the farmer will have the cash he needs to purchase modern inputs and to meet his credit obligations. (This is the point at which a bit of funds flow analysis is mixed in with the farm investment analysis.) One means is to calculate a separate cash budget as Brown suggests (1979, pp. 25-30). Another means is shown at the bottom of table 4-19. Here, a line is added to subtract the value of home-consumed production from the net benefit after financing. The remainder is the cash surplus (or deficit). If there is a deficit, it must be made up from family savings or other sources if the farmer is not to fall behind in his invest- ment plan or to default on his credit obligations. Alternatively, we may wish to adjust the amount of short-term credit extended or alter the conditions of long-term credit to avoid the cash deficit. The farm budget presented in table 4-19 assumes that the real burden of debt service will continue throughout the life of the loan the farmer receives. As in most countries, in the Paraguay project the lending terms to farmers call for repayment in nominal-that is, money-terms. In- terest is stated at a given rate, and the nominal amount of principal repayment is agreed upon. If, however, a country experiences inflation FARM INVESTMENT ANALYSIS 135 that reduces the real value of money over time, the result is that farmers whose debt service payments are fixed in money terms have a declining real burden of debt service. Some countries try to adjust for this by indexing loans so that the nominal amount a farmer pays changes to maintain the same real burden of debt service, but most do not. If Paraguay were expected to experience inflation, then the farm budget would be a more realistic indicator of income and incentive if it reflected the declining real burden of debt service. Predicting future inflation rates is difficult at the very least (and may lead to political complications for analysts in public agencies if the government has adopted a strong anti-inflation program). Past experience is some indica- tion of what future inflation may be. In 1977 the wholesale price index in Paraguay rose by 8 percent, so that rate might be accepted as an estimate of future inflation. If we assume constant inflation of 8 percent during the life of the loan, then the debt service each year will be reduced by dividing it by 1 plus the rate of inflation stated in decimal terms to reflect the declining real burden. The farm budget for the Paraguay example is recast in table 4-20 to incorporate this assumption. The table projects that the real value of the loan receipts in years 2 and 3 will remain the same-which is to say that their nominal value will increase by the amount of inflation. This is perhaps an unrealistic assumption in many countries. If so, not only the debt service but the real value of the loan receipts might be reduced by the amount of the inflation, and the farmer would have to invest more of his own resources to keep his investment program on schedule. (The details about how the loan receipts and debt service were calculated are given in the section "Computing Debt Ser- vice" and in table 4-26, below.) The recast farm budget in table 4-20 begins with the net benefit before financing, which is the same as that in table 4-19 since table 4-19 is cast in constant terms and the relative prices are correct. (The reader will recall that the prices in table 4-12, which formed one of the bases for table 4-19, were varied to allow for changing relative values.) Since all prices in both tables 4-19 and 4-20 maintain the same relation to each other or have been changed to reflect changing relations, the tables are, in effect, cast in terms of the value of the guarani in project year 1. The terms of the loan to the farmer from the Paraguayan National Development Bank are the same as those outlined in table 4-19 and are set in nominal terms. Comparing the debt service line in tables 4-19 and 4-20 shows the effect of assuming a declining real burden of debt service, as does a comparison between the two lines for the incremental net benefit after financing. Recasting the farm budget to reflect the declining real burden of debt service shows that the real return to the farmer for his own resources would rise from the 26 percent estimated in table 4-19 to 34 percent. The net benefit increase (discussed later in this chapter) would rise from 23 percent to 35 percent. Both increases, of course, reflect the declining real burden of the debt service. Casting the farm budget to reflect the declining real burden of debt service that occurs in inflationary circumstances certainly is more realis- tic than assuming a constant burden. It probably also will lead to a better Table 4-20. Farm Budget Assuming Declining Real Burden of Debt Service, 20-Hectare Mixed Farm, Paraguay Project (thousands of 0) Project year Item 1 2 3 4 5 6 7 8 9 10 1 12 13 14-19 20 Net benefit before financng' (359.2) 107.9 123.5 297.3 345.2 457.3 471.2 471.2 471.2 471.2 471.2 471.2 471 2 471.2 901.8 Financing b Loan receipts' 508.2 107.1 140.0 0 0 0 0 0 0 0 0 0 0 0 0 Debt servicec - 61.2 69.6 81.3 75.2 111.1 111.6 114.9 106.3 98.4 91.1 29.8 16.2 0 0 Net financing 508.2 45.9 70.4 ( 81.3) ( 752) (111.1) (111 6) (1149) (106.3) ( 98.4) ( 91.1) ( 29.8) ( 16.2) 0 0 Net benefit after financing Total 149.0 153.8 193.9 216.0 270.0 346.2 359.6 356.3 364.9 372.8 380.1 441.4 455.0 471.2 901.8 Without project' 219.9 221.8 226.1 226.1 226.1 227.8 227.8 227.8 227.8 227.8 227.8 227.8 227.8 227.8 227.8 Incremental ( 70.9) ( 680) ( 32.2) ( 10.1) 43.9 118.4 131.8 128.5 137.1 145.0 152.3 213.6 227.2 243.4 674.0 Cash position Net benefit after financing 149.0 153.8 193.9 216.0 270.0 346.2 359.6 356.3 364.9 372.8 380.1 441.4 455.0 471.2 901.8 Less home-consumed productiona 50.0 50.0 50.0 50.0 50.0 40.2 44.4 44.4 44.4 44.4 44.4 44.4 44.4 44.4 44.4 Cash surplus (or deficit) 99.0 103.8 143.9 166.0 220.0 306.0 315.2 311.9 320.5 328.4 335.7 397.0 410.6 426.8 857.4 Net present worth at 12 percent of all resources engaged = G416 thousandd Financial rate of return to all resources engaged = 18 percentd Net benefit-investment ratio at 12 percent of all resources engaged = 01,091.6 - 0675.4 = 1.62d Financial rate of return to the farmer's own resources = 34 percent' Net benefit increase = [(G2,282.3 - 01,686.4) - 1] x 100 = 35 percente Source: Calculated from other tables as noted. c. For details of the computation, see the section "Computing Debt Service" and a. From table 4-19. table 4-26 later in this chapter. b. The terms and conditions of the financing are assumed to be the same as those d. Calculated on the basis of the incremental net benefit before financing. (Note in table 4-19, note h. It is assumed that there will be a constant inflation of 8 percent that this is the same value as in table 4-19). For details about the method of during the term of the loans. The table is stated in real terms in constant guaranis of computation, see chapter 9. project year I (except for the nominal terms for the loan receipts). Since debt service e. Calculated on the basis of the incremental net benefit after financing. is denominated in nominal (money) terms, the real burden declines each year by the f. The net benefit increase is the present worth of the incremental net benefit amount of inflation. Loan receipts are stated in real terms under the entry for loan after financing with the project divided by the present worth of the net benefit after receipts, and the nominal amounts for the second and third-year loans are given. financing without the project expressed in percentage. See text for a discussion of The nominal amount is increased by the amount of inflation, this measurement. For details about the method of computing the present worth, see chapter 9. 138 FINANCIAL ASPECTS OF PROJECT ANALYSIS estimate of the real attractiveness of a project to farmers, since most farmers will have some sense of the effect of inflation on nominal values. Except for the additional computations needed to project the farm budget, such an approach creates no analytical complications. Project aggregations can simply be based on the farm budgets that assume a declining real burden of debt service, just as they would be if the budget assumed that the burden of the debt service would remain constant and that the loan would be indexed. Of course, allowing for a declining real burden of debt service in the farm budget would not change the economic rate of return of a project, since that is based on the net benefit before financing valued in economic terms (discussed in chapter 7). CosT OF FAMILY LABOR. A common conceptual problem met when pre- paring farm investment analyses is how to determine the cost of family labor. The general principle, as with most questions of valuation, is to value family labor at its opportunity cost; that is, the benefit the family must forgo to participate in the project. This is done simply and more or less automatically if the farm budget format recommended here is followed. This method has the tremendous practical advantage that the cost of family labor need not be estimated directly. Rather, the cost of family labor is taken to be what the family could earn in its next most remunera- tive alternative without the project. To accomplish this, the farm budget must compare the with-project situation with the without-project situa- tion, and the off-farm labor income must be included in the budget-at least if there is to be any change in the amount earned from off-farm labor. The cost of the family labor needed to adopt the with-project cropping pattern, then, is the labor income in the without-project situa- tion that must be given up. If the number of days of off-farm work must be reduced for the farm family to participate in the project, to that extent the cost of incremental family labor is the off-farm wage. If the with- project cropping pattern calls for a shift of family labor from one produc- tion activity on the farm to another, the cost of the labor shifted is implicitly set at the labor income forgone in the without-project activity. Finally, if more total family labor is called for in the with-project crop- ping pattern than in the pattern without the project, as is the case in the Paraguay example, this additional labor is implicitly priced at an oppor- tunity cost of zero, since no income must be forgone to use the labor in the with-project cropping pattern. This assumes, in effect, that the family would have worked more days of the year in the without-project situa- tion had there been suitable opportunities available either through addi- tional farm work or off the farm. Any incremental labor needed in the with-project cropping pattern compared with the without-project crop- ping pattern plus off-farm employment is assumed to be taken from undesired leisure given up. (Later, when the analyst converts from finan- cial prices to economic values, the off-farm earning would be valued at the appropriate shadow wage.) FARM INVESTMENT ANALYSIS 139 If the family would not, in fact, give up leisure for the amount it could earn from additional farm labor by participating in the project, then the proposed cropping pattern is unrealistic and should not be used. Such a situation could easily arise. In many societies, the period just after harvest is a time of family festivals. A proposed cropping pattern calling for substantial family labor during this time would in all likelihood be unacceptable to the farmers. In effect, we are saying that the family has a "reservation price" for leisure-the price at which the family is willing to give up leisure for additional work-that is greater than the return the family would receive for working the additional work days. Note that we do not attempt in this process to determine any value for leisure time. All we are saying is that the reservation price for leisure is greater than the return the family can earn from the proposed project's cropping pattern. Of course, the reservation price for leisure will vary widely with the circumstances. For substantially unemployed rural labor, the reserva- tion price may be quite low. But if every adult family member is already engaged some 200 days a year, then the reservation price for labor just after the harvest season may be rather high, for continued labor at this time may mean missing treasured family occasions. As the number of days of labor approaches the physical maximum, the reservation price will rise until almost no return is great enough to elicit additional labor. If we lay out the pattern farm budgets as suggested here, and family labor is valued at its opportunity cost, there is no need to have a separate entry for the value of family labor. To have such an entry amounts to double counting. Even so, because many analysts are uncomfortable presenting a budget with no directly identified allowance for family labor, a separate value for family labor is commonly found to be included erroneously in agricultural project analyses. COST OF LAND. A parallel approach to that suggested for the opportu- nity cost of family labor may be taken to determine the cost of land. This is especially convenient whenever the project does not contemplate a change in ownership but rather a change only in land use. If farmers shift from rainfed sorghum to irrigated rice without changing the land own- ership, as has happened in several agricultural projects along the major rivers of West Africa, the cost of the land is its contribution to the value of the sorghum production that the farmers must forgo to use the land for rice. This is automatically provided for when we lay out the farm budget to show the difference with and without the project. Therefore, a separate entry for the cost of land is not needed, either in the financial or in the economic accounts. When there is a separate rent paid by the farm family for the use of the land, then the rent is properly shown as a cost in the financial analysis- in both the without-project and the with-project situations-since it reduces the net benefit available to the family. However, when we con- vert this budget to efficiency prices for the economic analysis, as dis- cussed in chapter 7, simply casting the economic account on a with and 140 FINANCIAL ASPECTS OF PROJECT ANALYSIS without basis without entering the rent separately would be the simplest way to allow for the opportunity cost of land. If the land is to be purchased, the purchase price would properly be shown as a cost in the financial accounts. Again, however, in converting to efficiency prices for the economic analysis the opportunity cost would be taken as the economic value. As before, simply comparing the situa- tions with and without the project in the economic accounts is generally the most convenient approach and will correctly value the land at its opportunity cost. Sometimes, however, different approaches may be taken in the economic accounts, a topic to which we will return in chapter 7 in the subsection "Step 3. Adjustment for price distortions in non-traded items." Net Benefit Increase We should note that, although the farm budgets given in this chapter place a fair amount of stress on determining the net present worth, the financial rate of return, and the net benefit-investment ratio to the farm- er's own resources, these measures of project worth are in fact not very important to the farmer. Far more important to farmers is the actual amount of additional income they expect to receive. It is probably fair to say that for most small farmers the concept of capital return hardly plays any part in their decision. Indeed, in many farm budgets these measures of project worth are almost meaningless. For example, in the Third Agricultural Credit Project in Kenya, for the model ii smallholder in farm zone B, the return to the farmer's own capital resources is extremely high. This is so because it is proposed to lend to the farmer most of the cost of the incremental investment for a new dairy enterprise, and the incremental return from the new enterprise from year 2 onward is suf- ficient to make the incremental net benefit after financing positive. Thus, the farmer really needs very little in the way of his own capital resources to participate in the project, although he will still have to bear most of the risk. Despite the high rate of return, since the farmer's own capital contribution is small, the absolute amount of his return is also small. Indeed, the whole incremental net benefit after financing, or incremental farm family net benefit, is not all that great. Hence, no one would worry about the apparently very high windfall return the farmer would receive on his own capital resources engaged in the project. Farmers probably pay more attention to the potential increase in their incremental net benefit after financing, so it is convenient to have a measure that succinctly describes what that is. Schaefer-Kehnert (1980) has proposed the net benefit increase for this purpose. This is the present worth of the incremental net benefit after financing with the project, divided by the present worth of the net benefit after financing without the project, expressed in percentage terms. (The mechanics of determining the present worth are discussed in chapter 9.) In the farm budget for the Paraguay project pattern farm given in table 4-19, for example, at a 12 FARM INVESTMENT ANALYSIS 141 percent discount rate the present worth of the incremental net benefit after financing with the project is 02,071.7 thousand, and the present worth of the net benefit after financing without the project is 01,686.4 thousand. The net benefit increase, thus, is 23 percent {[(2,071.7 + 1,686.4) - 1] x 100 = 23}. The net benefit increase may be interpreted as the weighted average incremental increase in income the farmer will receive over the life of the project if he participates. The net benefit increase provides a basis for determining whether the increased income will be sufficient to attract farmers' participation in a project and for comparing easily the relative attractiveness to farmers of alternative project possibilities. Unit Activity Budgets We have discussed in considerable detail preparation of whole farm budgets for farm investment analysis. This generally is the preferable analytical approach in agricultural project analysis. An alternative approach, however, is to prepare a "unit activity budget"; that is, a budget which applies only to some particular investment activity-say, a hectare of fruit trees or a broiler chicken production unit. This approach is related to the "partial" budgeting commonly used by farm manage- ment specialists in that it examines the return to a single activity on the farm rather than to the farm as a whole, with that one activity incorpo- rated in the cropping pattern. Brown discusses partial budgets for agri- cultural project analysis (1979, pp. 25-30). Unit activity budgets are particularly convenient when a project fo- cuses on a single crop or livestock activity. Often these activities are considered as additions to existing farm activities that will encourage increased output of the commodity in question and will increase farm incomes. Usually it is thought that the activity can be added to the ongoing farm cropping pattern without disruption and without seriously reducing the resources available for other activities on the farm. Rather than develop a range of pattern whole farm budgets incorporating the new activity, many analysts choose simply to do a unit activity budget showing the cost and return per unit to the individual farmer who adopts the innovation and then to aggregate by multiplying the results by the number of hectares or of livestock production units to be included in the project. Unit activity budgets are used to good advantage where spec- ification of opportunity costs for land or labor is not crucial. They may be used when estimating the area is difficult or inappropriate and where it is considered that the labor involved will not be seriously competitive with other farm activities. They have been used, for example, as the basis for agricultural project analysis where the objective was to encourage small- scale planting of grapes for raisin production in Afghanistan, to encour- age stall feeding of cattle in Kenya, and to encourage the addition of a small dairy enterprise to existing farms in India. Unit activity budgets 142 FINANCIAL ASPECTS OF PROJECT ANALYSIS have the advantage of generally being easier to prepare, since it is not necessary to collect and analyze information on any farm production activity other than the one to be encouraged in the project. There are, however, significant limitations in unit activity budgets. The most important is that they fail to assess the effect of undertaking a new activity on the resource use of the farm and on overall farm income. In the absence of whole farm budgets, the analyst may give too little attention to the place of a proposed innovation in the cropping pattern of the entire farm and thus make an erroneous judgment about incentive effects. It may be overlooked that incorporating a particular crop or innovation in the farm as a whole may cause labor shortages arising either from competition for family labor or for the total labor supply in the area. The analyst may fail to appreciate the competition for land of a new crop with other crops grown on the farm. Using unit activity budgets instead of whole farm budgets also reduces the analyst's ability to assess the farmer's credit need and repayment capacity, which are influenced not only by the incremental income from a particular production innova- tion but also by the financial position of the farm as a whole. A major problem with unit activity budgets is that it is easy to overlook opportunity costs or to value them erroneously. One substantial advan- tage of laying out whole farm budgets in the manner suggested in this chapter is that this method correctly allows for the opportunity cost of land and labor-including, most importantly, family labor. Unit activity budgets generally are done directly on an incremental basis, rather than cast in a with-and-without form. This means that all opportunity costs must be estimated directly to obtain the incremental net benefit, and great care must be taken to see that they are correctly estimated. Concep- tually, of course, if the opportunity costs are correctly stated, there will be no difference in the estimated incremental net benefit, either to the individual farmer or to the society as a whole, whether the basis is a whole farm budget or a unit activity budget. In practice, however, the situation is quite different. Both the opportunity cost of the land to be used for the new crop or livestock undertaking and the opportunity cost of family labor must be imputed rather than derived from established market prices. Such estimates are difficult to make correctly; they are frequently in error and will give results that will differ from those that would be obtained by using whole farm budgets. (The full "partial" budgeting technique developed by farm management specialists can also be used for estimating the opportunity cost of land and labor, but the full approach is not often used in practice for agricultural project analysis.) We may illustrate a unit activity budget with an example drawn from the Indian Cashewnut Project. The project is to help finance a cashew production program in four Indian states; the project includes 35,000 hectares to be developed by smallholders. The project analyst chose to use the unit activity approach because most cashews in India are grown by smallholders in small clumps, in hedgerows, or as backyard trees. Preparing pattern whole farm budgets that reasonably represented the FARM INVESTMENT ANALYSIS 143 range of possible combinations of farm sizes and cashew production activities would entail a large number of examples. Instead, six unit activity budgets for a hectare of cashews each were prepared for new plantings and two for rehabilitation of existing plantings. The in- cremental net benefit from each unit activity budget was then multiplied by the area foreseen in the project for each pattern to obtain the contribu- tion to the total project benefit of increased cashew production by small- holders. The relevant background information to the Indian project is given in table 4-21. This gives the value of production and the investment and operating expenditure. (The symbol for Indian rupees is Rs.) In the budget as prepared by the analyst, no distinction was made between investment and operating expense; instead, both were simply defined as "produc- tion" cost, a conceptually correct approach. To keep this presentation parallel to that for the Paraguay whole farm budget discussed earlier in this chapter, however, all expenditure before the trees begin to bear is rather arbitrarily considered investment, whereas that incurred after bearing begins is considered operating expenditure. The advantage of this treatment is that it makes it analytically convenient to calculate the incremental working capital needed. In the summary reproduced here, the details about the amounts and unit prices of the materials needed, which were included in the original project analysis, have been omitted to conserve space. The background information points up some of the problems of using the unit activity approach to budgeting. Among the investment and operating expenditures, the analyst has indeed included all the oppor- tunity costs. Both the opportunity cost for land and for labor were estimated directly. In the Indian Cashewnut Project, the trees are assumed to be planted in areas otherwise put to no economic use; the opportunity cost of the land can thus be appropriately taken as zero. In other instances, however, the opportunity cost of the land might be positive, and the points we have made earlier in the "Farm budget" subsection about estimating the opportunity cost of land would have to be considered. It might be appropriate, for instance, to use rent as an estimate of the contribution of land to the value of production forgone to undertake the new activity. In still other instances, the purchase price of the land might appropriately account for its opportunity cost, even though purchase price is generally a poor estimate. This might be the case in a livestock-fattening project, for instance, where the area in- volved is small and the opportunity cost of the land is minor in relation to overall costs, so that using the purchase price would not lead to a signif- icant error in the investment decision. Finally, in some instances it may prove necessary to estimate the contribution of the land to the forgone production directly, say, by assigning the residual after deducting all other costs from the value of production to land. This might be the case if farmers are expected to shift some of the land they already crop to another production activity. Another problem with the unit activity budget approach is pointed up Table 4-21. Value of Production, Investment, and Operating Expenditure, 1-Hectare Planting Model, Cashewnut Project, Smallholder Component, Karnataka, India Project year Item 1 2 3 4 5 6 7 8 9 10 11-40 Value of production Yield (kg/ha) 0 0 0 50 150 400 600 700 800 900 900 Price' (Rs/kg) - - - 4.1 4.2 4.3 4.4 4.6 4.8 4.9 5.1 Gross value of production (Rs) 0 0 0 205 630 1,720 2,640 3,220 3,840 4,410 4,590 Investment and operating expenditureb Land Rent (opportunity cost) (Rs)' 0 0 0 0 0 0 0 0 0 0 0 Total land (Rs) 0 0 0 0 0 0 0 0 0 0 0 Labor (work days) Land clearing, development 70 0 0 0 0 0 0 0 0 0 0 Pit digging 15 0 0 0 0 0 0 0 0 0 0 Planting seedlings 6 0 0 0 0 0 0 0 0 0 0 Crescent bunding 0 25 25 0 0 0 0 0 0 0 0 Ringweeding 0 20 15 0 0 0 0 0 0 0 0 Gap filling 0 1 0 0 0 0 0 0 0 0 0 Bund maintenance 0 0 0 4 5 5 5 5 5 5 5 Mulching, weeding, watering 10 0 10 20 15 12 10 10 10 10 10 Fertilizer application 4 5 5 5 5 5 5 5 5 5 5 Plant protection 2 2 4 5 9 10 10 10 10 10 10 Harvesting 0 0 0 3 10 16 24 28 32 36 36 Miscellaneous 3 3 3 3 5 5 5 5 5 5 5 Total labor 110 56 62 40 49 53 59 63 67 71 71 Wage (Rs/day) 8 8 8 8 8 8 8 8 8 8 8 Labor cost (Rs) 880 448 496 320 392 424 472 504 536 568 568 Materialsd (Rs) Plant materials 50 10 0 0 0 0 0 0 0 0 0 Fertilizer 150 250 350 400 400 400 400 400 400 400 400 Plant protection 40 80 120 150 175 175 175 175 175 175 175 Miscellaneous 20 20 20 20 20 20 20 20 20 20 20 Total materials 260 360 490 570 595 595 595 595 595 595 595 Total investment 1,140 808 986 0 0 0 0 0 0 0 0 Total operating expenditure 0 0 0 890 987 1,019 1,067 1,099 1,131 1,163 1,163 Rs Indian rupees; kg. kilograms. b. The analyst of the project did not distinguish between investment and Source: Adapted from World Bank, "India, Cashewnut Project, Staff operating expenditure, preferring instead to treat both simply as "produc- Appraisal Report," 2437-IN (Washington, D.C., 1980; restricted circulation), tion" cost. Production cost in years I to 3 before the trees bear is taken to be annex 4, table 1. investment, in years 4 to 40 to be operating expenditure. a. Based on projected f.o.b. price adjusted to give the export parity value at c. Trees are assumed to be planted in areas that otherwise would be put to the farm gate. Details given in the original project report, from which this no economic use. example is drawn, are not reproduced here. d. Details of application rates and prices given in the original project report are not reproduced here. 146 FINANCIAL ASPECTS OF PROJECT ANALYSIS by the background information. Labor represents a high proportion of the operating expenditure, characteristically on the order of half. Labor has been valued at a daily wage of Rs8, and this in turn was shadow- priced in the economic analysis at 70 percent of the market rate to allow for rural unemployment along the lines discussed in chapter 7. But, since most of the smallholder plantings will be in very small areas, even backyards, it is likely that family members will do most of the work. And they will probably do this at odd times, when they otherwise do not have opportunities for productive employment either on their own holdings or as hired labor. Thus, the opportunity cost to the family may be close to zero and the incremental net benefit correspondingly larger, making the project that much more attractive to farmers and reducing the need for credit. Similarly, when converting the financial prices to economic values along the lines discussed in chapter 7, if much of the labor is supplied by the family at times when there are no other opportunities for productive employment, then the economic value of the labor may also be close to zero-and the economic attractiveness of the smallholder component of the project that much more attractive from the standpoint of the economy as a whole. The unit activity budget is given in table 4-22. Its format follows that adopted for the whole farm budget. From the inflow (including a subsidy for planting) is subtracted the outflow to obtain the incremental net benefit before financing. Discounted, this will give the net present worth, finan- cial rate of return, or net benefit-investment ratio to all resources en- gaged. Changing the financial prices to economic values and omitting transfer payments (see chapter 7) will give the incremental net benefit in economic terms. This may then be aggregated by multiplying by the number of units expected in the project to give the total incremental net benefit contributed to the project by the on-farm production. Proceeding to the financing, loan receipts less debt service give the net financing. The terms and conditions of the loans are given in the notes to the table. (A detailed exposition of how the debt service was calculated is given, in the subsection on computing debt service, using "equal install- ments with interest capitalized," later in this chapter.) The com- putation is made more complex because the interest is capitalized during the investment period. Also, the interest rate for the loan is 10.5 percent, and many discounting tables do not give factors for high fractional interest rates. The relevant factors, however, may easily be calculated on a simple hand calculator (as discussed in chapter 10 under "Calculator Applications in Project Analysis"). These credit estimates again raise the problem of estimating opportunity costs. The amount of credit is calcu- lated assuming that the farmer will pay Rs8 per day for all the labor engaged. But if family labor were used for which the opportunity cost were lower, perhaps even zero, then the farmer would not need so much credit to undertake the new activity. Were credit extended on the basis of the unit activity budget, there might be more lent than necessary to further the project, and there would be significant "leakage." This could be avoided by a credit agency if its staff made separate analyses for each FARM INVESTMENT ANALYSIS 147 borrower based on the borrower's real costs rather than simply applying a rule of thumb derived from the unit activity budget. Finally, we reach the entry for incremental net benefit after financing. Discounted, this will give the financial rate of return to the farmer's own resources, assuming that the farmer invested his own capital in the project as indicated in the budget and that all costs have been correctly estimated. Computing Debt Service In many farm budgets there will be a credit element, and the analyst will have to calculate the amount of the debt service. In this section, we will briefly review how to compute the amount of interest due and the amount of the principal repayment for four different repayment terms. We will also consider how to adjust for the declining real burden of debt service when there is inflation. Computations will be carried to the nearest whole currency unit or to some other convenient rounding aggre- gate, since that is the common practice in most farm budgets used in project analysis. Credit agencies, of course, will have to work to the nearest unit in common use for commercial transactions: cents, paise, nguawa, or whatever. In the examples given here, where the term of the loan is a year or longer we will follow the accounting convention adopted-that loans are to be received at the end of a project year and that debt service is to begin in the following year. Often in project accounts, however, the analyst will choose to assume that the loan is made at the beginning of the accounting period and that debt service is paid at the end. As noted, this leads to the anomaly that for a loan of a year or longer both the loan receipt and the first interest payment, and perhaps even the first principal repayment, are shown within the same project year. It can also lead to an understate- ment of the short-term credit the farmer will need and to an overstate- ment of his financial rate of return. Simple interest The easiest term to calculate, of course, is common simple interest such as that found in short-term credit lent for seasonal expenses. In the Kenya Third Agricultural Credit Project, for example, the farmer re- ceives a loan in year I of KShl,374, which he is to repay twelve months later at 11 percent interest. (The symbol for Kenyan shillings is KSh.) Thus, the interest is KShl51 (1,374 x 0.11 = 151). The total amount to be repaid by the Kenyan farmer is the principal borrowed plus the interest, or KShl,525 (1,374 + 151 = 1,525). If we are concerned only about the total amount to be repaid and do not need to separate interest and principal, as is often the case in preparing farm budgets, then it is simpler to calculate the total repayment in one step by multiplying the principal Table 4-22. Unit Activity Budget, 1-Hectare Planting, India Cashewnut Project (Rs) oo Project year Item 1 2 3 4 5 6 7 8 9 10 11-13 14-39 40 Inflow Gross value of productiona 0 0 0 205 630 1,720 2,640 3,220 3,840 4,410 4,590 4,590 4,590 Subsidyb 300 300 300 0 0 0 0 0 0 0 0 0 0 Incremental residual value'c - - - - - - - - - 1,163 Total 300 300 300 205 630 1,720 2,640 3,220 3,840 4,410 4,590 4,590 5,753 Outflow Investment' 1,140 808 986 0 0 0 0 0 0 0 0 0 0 Incremental working capitald - - 890 97 32 48 32 32 32 0 0 0 0 Operating expenditurea - - - 890 987 1,019 1,067 1,099 1,131 1,163 1,163 1,163 1,163 Other 0 0 0 0 0 0 0 0 0 0 0 0 0 Total 1,140 808 1,876 987 1,019 1,067 1,099 1,131 1,163 1,163 1,163 1,163 1,163 Incremental net benefit before financing ( 840) ( 508) (1,576) ( 782) ( 389) 653 1,541 2,089 2,677 3,247 3,427 3,427 4,590 Financinge Loan receipts 783 468 1,482 733 338 0 0 0 0 0 0 - - Debt service 0 0 0 0 0 499 499 1,108 1,108 1,108 1,108 - - Net financing 783 468 1,482 733 338 ( 499) ( 499) (1,108) (1,108) (1,108) (1,108) - - Incremental net benefit after financing ( 57) ( 40) ( 94) ( 49) ( 51) 154 1,042 981 1,569 2,139 2,319 3,427 4,590 Net present worth at 12 percent of all resources engaged = Rs 9,324f Financial rate of return to all resources engaged = 29 percentt Net benefit-investment ratio at 12 percent of all resources engaged = 12,318 + 2,994 = 4.11I Financial rate of return to the farmer's own resources = >50 percentg Source: Same as table 4-21. subsidy received and less the gross value of production in years when the net a. From table 4-21. benefit before financing is negative. In year 4, for example, the amount of the b Participatingsmallholdersreceivea25 percent subsidyof the cost of new loan is 95 percent of the incremental working capital plus the operating planting or Rs900 per hectare, whichever is less. expenditure less the gross value of production {[0.95(97 + 890)] - 205 = 733}. c. The incremental residual value consists entirely of the working capital. It Loans extend for twelve years, including a six-year grace period beginning is assumed the trees have no residual value at the end of the project. with the year after the first loan is made. That is, repayment of all loans begins d. The incremental working capital is calculated on the assumption that all in year 8 after termination of the six-year grace period from years 2 through 7. operating expenditure should be taken as the basis for the calculation. For Interest is capitalized during the period of disbursement; interest only is paid each year 100 percent of the incremental operating expenditure is taken as in years 6 and 7; and equal installments of debt service are made from years 8 recommended in table 4-3. This makes the implicit assumption that the labor through 13. See the section "Computing Debt Service" and table 4-25 for an cost represents an accurate estimate of the opportunity cost of the family labor explanation of how the calculations are made. used. See text for discussion. f. Calculated on the basis of the incremental net benefit before financing. e. Participating smallholders may borrow 95 percent of investment, in- For details about the method of computation, see chapter 9. cremental working capital, and operating expenditure less the amount of g. Calculated on the basis of the incremental net benefit after financing. 150 FINANCIAL ASPECTS OF PROJECT ANALYSIS by 1 plus the interest rate stated in decimal terms to reach the total amount to be repaid of KShl,525 (1,374 x 1.11 = 1,525). Often, short-term credit is extended for a period less than a full year. In the Ceara Rural Development Project in northeast Brazil, for example, a farmer is assumed to receive short-term credit amounting to Cr$3,056 at an annual interest of 7 percent. (The symbol for Brazilian cruzeiros is Cr$.) He is to repay the loan at the end of six months, so he need pay interest for only that period. The amount of interest due is only six- twelfths, or half the annual amount, so the analyst simply divided the annual amount by two to obtain the interest payment of Cr$107 (3,056 x 0.07 + 2 = 107). The total repayment, therefore, is the amount of principal plus interest, or Cr$3,163 (3,056 + 107 = 3,163). It would have been an easier computation to have done the calculation in one step by first dividing the interest rate in decimal form by 2, then adding 1 and multiplying the amount of the principal by that sum {3,056 x [1 + (0.07 + 2)] = 3,163}. Of course, fractional interest rates present no problem in these calcula- tions because discounting tables are not used. In Morocco, for example, farmers participating in the Doukkala II Irrigation Project receive short- term credit through the Moroccan Regional Agricultural Development Office at an annual interest rate of 9.5 percent. In the farm budget prepared for the project analysis, a farmer on a 4-hectare farm is assumed to receive a short-term loan of DH4,395 to be repaid in six months. (The symbol for Moroccan dirhams is DH.) His repayment of principal and interest, thus, is DH4,604 {4,395 x [1 + (0.095 + 2)] = 4,604}. Repayment of equal amounts of principal When loans extend beyond one year, interest must be paid on any outstanding balance, and the way in which the principal will be repaid must be determined. The simplest way to calculate this term is to assume that the principal will be repaid in equal annual installments, with interest paid on the remaining outstanding balance. On long-term loans the first repayment of principal often will not be due for several years so that the farmer can build up his production before beginning to repay the amount he has borrowed. This grace period begins at the time the loan is extended and continues for over a year or more after. Thus, a four-year grace period for a loan received at the end of project year 1 would mean that the grace period would be project years 2 through 5, and the first repayment of principal would be due at the end of project year 6. (If the accounting convention for farm investment analysis we have adopted were not used, and the loan were assumed to be made at the beginning of the project year, then the four-year grace period would be years 1 through 4, and the first repayment of principal would be at the end of project year 5.) Interest on the outstanding balance is usually paid during the grace period, although it may be forgiven or capitalized as discussed below. The example in table 4-23 from the Honduras Agricultural Credit FARM INVESTMENT ANALYSIS 151 Project, taken from a pattern farm budget for a 50-hectare beef-fattening unit, illustrates the debt service computation on a loan for which the principal is to be paid in equal amounts and interest is to be paid on the outstanding balance. The computation when the budget assumes our accounting convention for farm investment analysis is shown in the first part of the table. The farmer is to be loaned a total of L12,699 in three installments during the first three years of the project. (The symbol for Honduran lempiras is L.) For the first installment he is allowed a three- year grace period, for the second a two-year grace period, and for the third a one-year grace period. Then he is to repay his loan over a three- year period from years 5 through 7. The principal is to be repaid in three equal installments of L4,233 (12,699 + 3 = 4,233). (In the actual project, the analyst chose to change the principal repayments slightly to make the loan balance a round figure.) The interest rate is 11 percent a year. The interest paid in year 3, for instance, is computed on the basis of the loan of L3,123 received at the end of year 2 plus the loan of L7,767 received at the end of the first year that is still outstanding, or a total principal on which interest is to be paid of L10,890. The interest due is L1,198 [(7,767 + 3,123) x 0.11 = 1,198]. As the principal is repaid, in- terest is due only on the remaining outstanding balance. We assume that the loan repayment is made at the end of the year, so interest is due on the full amount of the principal outstanding at the end of the previous year. Thus, in year 4 interest must be paid on the total amount of the loan received, L12,699, and amounts to L1,397 (12,699 x 0.11 = 1,397).In year 5 a repayment of L4,233 is made, so that the outstanding balance at the end of the year is L8,466 (12,699 - 4,233 = 8,466). It is assumed, however, that the principal repayment is made at the end of the year, and thus interest must be paid for the full year on the L12,699 outstanding at the end of the previous year, or another interest payment of L1,397. For year 6 the outstanding balance at the end of the previous year has been reduced by the principal repayment of L4,233 made at the end of year 5, so the interest is calculated on the outstanding balance of L8,466 and amounts to L931 (8,466 x 0.11 = 931). In the second part of table 4-23, the Honduras example is recast assum- ing that the loan is made at the beginning of the accounting year and the first interest payment is due at the end of the same year. The computa- tions remain the same; only the years in which the figures appear in the budget vary. In the first year a loan of L7,767 is received at the beginning of the year, and interest is paid on this amount at the end of the year, so an interest payment of L854 appears in year 1 (7,767 x 0.11 = 854). The three-year grace period for the first loan begins in the year of the loan, so it extends from year 1 through year 3. Repayment of principal begins in year 4 with a payment of L4,233. Interest is also paid at the end of year 4 for the amount of the loan outstanding during the year, which is L12,699, shown at the end of year 3; the interest amounts, of course, to L1,397 (12,699 x 0.11 = 1,397). Note that the effect of assuming the loan to be made at the beginning of the year is simply to bring forward every interest payment and loan repayment by one accounting period. 152 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 4-23. Debt Service Computation Assuming Repayment of Equal Amounts of Principal, Beef-Fattening Unit, Agricultural Credit Project, Honduras (Honduran Ls) Project year Item 1 2 3 4 5 6 7 Loan receipts beginning in year 1, debt service beginning in year 2 Loan receipts and balances Loan receipts 7,767 3,123 1,809 0 0 0 0 Outstanding balance at end of year 7,767 10,890 12,699 12,699 8,466 4,233 0 Debt Service Interest - 854 1,198 1,397 1,397 931 466 Repayment of principal - - - - 4,233 4,233 4,233 Total - 854 1,198 1,397 5,630 5,164 4,699 Net financing 7,767 2,269 611 (1,397) (5,630) (5,164) (4,699) Internal rate of return to net financing flow = 11 percent' Loan receipts beginning in year 1, debt service beginning in year I Loan receipts and balances Loan receipts 7,767 3,123 1,809 0 0 0 - Outstanding balance at end of year 7,767 10,890 12,699 8,466 4,233 0 - Debt service Interest 854 1,198 1,397 1,397 931 466 - Repayment of principal - - - 4,233 4,233 4,233 - Total 854 1,198 1,397 5,630 5,164 4,699 - Net financing 6,913 1,925 412 ( 5,630) (5,164) (4,699) - Internal rate of return to net financing flow = 15 percenta L Honduran lempiras. Source: Adapted from World Bank, "Appraisal of an Agricultural Credit Project-Hon- duras," 1044a-HO (Washington, D.C., 1976; restricted circulation), annex 4, table 7. See text for a discussion of how the figures in this table were derived. a. For details about the method of computation, see chapter 9. An advantage of our accounting convention for farm investment analy- sis becomes evident at this point. If we discount the net financing flow when the farm budget is cast assuming the loan to be received at the beginning of the accounting period, we find the internal rate of return to be 15 percent; but we know it should be 11 percent because the interest rate on the loan is 11 percent. (The internal rate of return is the weighted average return to all resources while they are still engaged. The method of computation is discussed in the section devoted to the topic in chapter 9.) The error is introduced by the assumption that the loan is made at the beginning of the first year and that the first interest payment will be made at the end of the first year. In contrast, when the farm budget uses FARM INVESTMENT ANALYSIS 153 our accounting convention, which assumes the loan to be received at the end of the accounting period and the interest payment to be made at the end of the following period, the internal rate of return to the net financing flow is exactly 11 percent, which we know to be correct from the assump- tion about the terms of the loan. Equal installments Farmers would usually prefer to pay the same amount every year on a long-term loan rather than to make the varying payments when princi- pal is repaid in equal annual amounts. Thus, it is common practice in most long-term transactions to arrange for the debt service to be paid in a series of equal annual installments, also called level payments or an equated annuity. The calculation of these equal installments can be illustrated by re- turning to the Paraguay pattern farm budget of table 4-19, for which the financing is calculated in table 4-24. In this project, the farmer receives a loan from the Paraguayan National Development Bank for 90 percent of the investment expenditure and for 90 percent of the incremental work- ing capital during the investment period, which is years 1 through 3. The loan is for ten years with a four-year grace period during which interest is paid. The loan is repaid in six equal annual installments. The loan received each year is treated as a separate transaction. Thus, for the loan received at the end of year 1, the grace period is years 2 through 5, and the loan is repaid during years 6 through 11. The interest rate is 13 percent. During the four-year grace period, the interest is calculated at 13 percent on the outstanding balance at the end of the previous year. For the first-year loan of 0508.2 thousand, for example, the interest due at the end of year 2 is 066.1 thousand (508.2 x 0.13 = 66.1). After the grace period, the principal is to be repaid, together with interest on the out- standing balance, in six equal installments. To calculate the amount of each annual installment, we will need to have the capital recovery factor for 13 percent for 6 years. Usually, this may conveniently be obtained from a set of standard tables such as Compounding and Discounting Tables for Project Evaluation (Gittinger 1973). When a fractional interest rate is involved, however, it may be difficult to find a set of tables that gives the capital recovery factor at a specific fractional rate, although many give factors for the more common fractional rates. If no table is readily available, the capital recovery factor may be easily computed using a simple hand calculator. (The computation is illustrated in the last section of chapter 10, "Calculator Applications in Project Analysis.") Consulting the tables [the relevant portion is reproduced from Gittinger (1973) in compounding and discounting table 1 on page 156], we turn to the page for 13 percent interest and follow down the column for the capital recovery factor to find the factor opposite the sixth year, which is 0.250 153. Now, we simply multiply the amount of the outstanding balance of Q508.2 thousand (due on the first-year loan at the end of the grace period in year 5) by the capital recovery factor to obtain the annual installment of Q127.1 thousand (508.2 x 0.250 153 = 127.1). Table 4-24. Debt Service Computation Assuming Equal Installments, 20-Hectare Mixed Farm, Paraguay Project (thousands of 0) Project year Item 1 2 3 4 5 6 7 8 9 10 11 12 13 Investment and working capitala Investment 523.6 110.6 126.5 0 0 0 0 0 0 0 0 0 0 Incremental working capital 41.1 8.4 29.1 13.4 25.6 2.3 0 0 0 0 0 0 0 Total 564.7 119.0 155.6 13.4 25.6 2.3 0 0 0 0 0 0 0 Loan receipts and balances Loan receipts 508.2 107.1 1400 0 0 0 0 0 0 0 0 0 0 Outstanding balance at end of year First-year loan 508.2 508.2 508.2 508.2 508.2 447.2 378.2 300.3 212.2 112.7 ob Second-year loan - 107.1 107.1 107.1 107.1 107.1 94.2 79.6 63.1 44.5 23.5 ob Third-year loan - - 140.0 140.0 140.0 140.0 140.0 123.2 104.2 82.7 58.5 31.1 ob Total 508.2 615.3 755.3 755.3 755.3 694.3 612.4 503.1 379.5 239.9 82.0 31.1 0 Debt service First-year loan Interest - 66.1 66.1 66.1 66.1 66.1 58.1 49.2 39.0 27.6 14.7 Repayment of principal - 0 0 0 0 61.0 69.0 77.9 88.1 99.5 112.4 Subtotal - 66.1 66.1 66.1 66.1 127.1 127.1 127.1 127.1 127.1 127.1 Second-year loan Interest - - 13.9 13.9 13.9 13.9 13.9 12.2 10.3 8.2 5.8 3.1 Repayment of principal - - 0 0 0 0 12.9 14.6 16.5 18.6 21.0 23.7 Subtotal - - 13.9 13.9 13.9 13.9 26.8 26.8 26.8 26.8 26.8 26.8 Third-year loan Interest - - - 18.2 18.2 18.2 18.2 18.2 16.0 13.5 10.8 7.6 4.0 Repayment of principal - - - 0 0 0 0 16.8 19.0 21.5 24.2 27.4 31.0 Subtotal - - - 18.2 18.2 18.2 18.2 35.0 35.0 35.0 35.0 35.0 35.0 Total - 66.1 80.0 98.2 98.2 159.2 172.1 188.9 188.9 188.9 188.9 61.8 35.0 Net financing 508.2 41.0 60.0 ( 98.2) ( 98.2) (159.2) (172.1) (188.9) (188.9) (188.9) (188.9) (61.8) (35.0) Source: Calculated from table 4-19. See text for a discussion of how the b. The total repayments of principal do not exactly equal the loan receipts calculations were made. because of rounding. The outstanding balance, however, is shown as zero. a. From table 4-19. 156 FINANCIAL ASPECTS OF PROJECT ANALYSIS COMPOUNDING AND DISCOUNTING TABLES 1. Capital Recovery Factor, 13 Percent Interest RATE 13% CAPITAL RECOVERY FACTOR Annual payment that will repay a $1 loan in X years with compound interest on the unpaid balance Year 1 130000 1 599 484 2 423 522 3 336 194 4 284315 5 C250 153) 6 226 111 7 208 387 8 194869 9 184290 10 175841 11 168986 12 Source: Gittinger (1973), p. 27. Each annual installment consists of varying proportions of interest and principal. By inspection, we do not know how much of any given installment is interest and how much is repayment of principal. The amounts can, of course, be calculated, and one method is illustrated in table 4-24. The interest due on the outstanding balance is subtracted from the annual installment, and the remainder is taken to be the prin- cipal repayment. Thus, for the first-year loan for year 6 'he interest is 066.1 thousand, and the repayment of the principal is 061.0 thousand (127.1 - 66.1 = 61.0). Subtracting the principal repayment from the out- standing balance of the loan at the end of year 5 of 0508.2 thousand means that at the end of year 6 we have an outstanding balance due of only 0447.2 thousand (508.2 - 61.0 = 447.2). Now, in year 7, the farmer must pay interest of 058.1 thousand on that outstanding balance (447.2 x 0.13 = 58.1). The annual installment in year 7, of course, re- mains 0127.1 thousand, so that when we subtract the interest payment from the installment we have a principal repayment of 069.0 thousand (127.1 - 58.1 = 69.0), and this reduces the outstanding balance at the end of year 7 to 0378.2 thousand (447.2 - 69.0 = 378.2). The same process continues to the end of the loan period in year 11. In this instance, the total principal payment shown is 00.3 thousand less than the loan re- ceived because of rounding. Calculating the interest and repayment of FARM INVESTMENT ANALYSIS 157 Table 4-25. Debt Service Computation Assuming Equal Installments with Interest Capitalized, 1-Hectare Planting, India Cashewnut Project (Rs) Compounding factor Principal and interest Yearof Amount of for I due at end loan loan (10.5 percent) of fifth year 1 783 1.490 902 1,167 2 468 1.349 233 631 3 1,482 1.221 025 1,810 4 733 1.105 000 810 5 338 1.000 000 338 Total 3,804 4,756 Interest during sixth and seventh years = Rs4,756 x 0.105 = 499 Combined annual installment of interest and principal repayment due from eighth through thirteenth years = 4,756 x 0.232 982 = 1,108 Source: Same as table 4-21. See text for a discussion of how the calculations were made. principal year by year as done here is generally unnecessary; simply calculating the equal annual installment using the capital recovery fac- tor ordinarily will suffice. Equal installments with interest capitalized In some loan transactions, the lender will agree to "capitalize" the interest due during the grace period. This means that the borrower need not pay any interest during the grace period; the interest due is, in effect, added to the principal of the loan (hence the term "capitalize"). When the repayment of principal begins, the amount borrowed plus the interest added to the principal during the grace period is then repaid in a series of equal installments. We may illustrate how to calculate the interest payment and the repayment of principal by an example adapted from the Indian Cashew- nut Project (discussed earlier in connection with unit activity budgets). The credit computation for the India project is laid out in table 4-25. A farmer is to be loaned Rs3,804, disbursed over five years, to establish a stand of cashewnut trees. The loan term is for twelve years at 10.5 percent interest with a six-year grace period. Interest due during the disburse- ment period in years 1 through 5 is added to the principal-that is, capitalized. Interest on the capitalized amount is to be paid in years 6 and 7. Repayment of the principal plus capitalized interest is to be made in six equal annual installments beginning at the end of the eighth year and ending at the completion of the thirteenth year. For each year that the loan is being disbursed, the amount of the disbursement is multiplied by the compounding factor for 1 for the 158 FINANCIAL ASPECTS OF PROJECT ANALYSIS remaining length of the disbursement period to determine the amount of principal and interest due on that disbursement at the end of the dis- bursement period. The compounding factor for 1 may be obtained from Gittinger (1973) or from a similar source, or it can be calculated using a simple electronic hand calculator (see chapter 10, the section "Calcula- tor Applications in Project Analysis"). For the disbursement made in year 1, for example, the amount of principal and capitalized interest due by the end of the fifth year is calculated by multiplying the principal re- ceived, Rs783, by 1.490 902, which is the compounding factor for 1 at 10.5 percent interest for the number of years after the loan is disbursed until the end of the fifth year-in this case, four years. The result is a total due of Rsl,167 (783 x 1.490 902 = 1,167). The amounts of principal and in- terest due on each disbursement at the end of the fifth year are then totaled to determine the total principal and interest due at the end of that year. Interest is paid on that capitalized interest in years 6 and 7 in the amount of Rs499 (4,756 x 0.105 = 499). The annual installment neces- sary to pay the interest due and to repay the principal in six equal payments is determined by taking the total value of Rs4,756, the loan outstanding at the end of the fifth year including capitalized interest, and multiplying it by 0.232 982, the capital recovery factor for six years at 10.5 percent interest, to obtain the annual installment of Rsl,108 thousand (4,756 x 0.232 982 = 1,108). (The capital recovery factor for six years at 10.5 percent interest was calculated by taking the reciprocal of the present worth of an annuity factor for six years at 10.5 percent. See chapter 10, the section "Calculator Applications in Project Analysis," for a discussion of how to make the computation using a simple calculator. Declining real burden of debt service The examples of debt service calculation to this point have assumed that debt service will be constant in real terms. Yet in most countries lending terms to farmers call for repayment in nominal-that is, money-terms. Interest is stated at a given rate, and the nominal amount of principal repayment is agreed upon. If there were to be inflation, which would reduce the real value of money over time, the result would be that farmers would have a declining real burden of debt service over the life of the loan. If a farmer agrees to make a series of fixed annual installments to repay his loan, the real burden of that fixed installment is reduced by the extent the value of money declines. (Some countries index loans so that the nominal amount the farmer pays increases with infla- tion to maintain the farmer's real debt burden.) We have noted that it is common practice in project analysis to deal with inflation by assuming that all prices will move by the same propor- tion. Thus, relative prices remain the same-or the analyst changes the price he uses to reflect the change in relative value. Our calculations, then, are done at constant prices. This convention generally is appropri- ate for farm investment analysis, with one important exception-repay- FARM INVESTMENT ANALYSIS 159 ment of credit in fixed money terms. When there is inflation, if our farm budget shows the same amount of debt service to repay a loan each year, we in effect are assuming that the loan is indexed and that its real burden will remain the same relative to all other prices. The opposite, however, is often true-inflation raises the nominal prices of the goods and services the farmer buys and sells, but the nominal amount of the debt burden remains the same. Thus the real burden falls, and if our project accounts are cast in constant terms the debt service should be reduced to reflect the changing value of the debt service payment relative to other prices. Such adjustments have been infrequent in project analysis to date, but with continuing high inflation in many countries it is a reasonable ex- pectation that they will become more common. An illustration of a farm budget that assumes a declining real burden of debt service, based on the farm budget for the Paraguay project used in table 4-19, was given in table 4-20. The debt service under this assump- tion is worked out on the basis of equal nominal annual installments in table 4-26. It is assumed that there will be constant inflation of 8 percent during the period of the financing. The terms and conditions of the financing are the same as those used in the example of equal annual installments in table 4-24-the loan is for ten years at 13 percent interest, with a four-year grace during which interest is paid and with six equal annual installments of interest and repayment of principal thereafter. The loan receipts in real terms are taken from table 4-24. They are, in fact, stated in constant terms in guaranis of project year 1. It is assumed that the farmer will continue the real investment program laid out in the farm budget in constant terms of table 4-18, so that in nominal terms the second- and third-year loans will increase by the amount of the inflation. To calculate the nominal amounts, the real value is multiplied by the compounding factor for I for the number of years after project year 1, which is the base year for the computation. [The compounding factor for 1 may be obtained from Gittinger (1973) or some similar source.] The nominal amount of the second-year loan, then, would be its real value of 0107.1 thousand multiplied by 1.080 000, the compounding factor for 1 for 8 percent (the assumed inflation rate) for one year, and this gives the result of 0115.7 thousand (107.1 x 1.080 000 = 115.7). The nominal amount of the third-year loan is the real value of 0140.0 multiplied by 1.166 400, the compounding factor for 1 for two years, and this gives the result of 0163.3 thousand (140.0 x 1.166 400 = 163.3). For this and all other calculations where the compounding factor for 1 is used, repeated multiplications or divisions may be used (140.0 x 1.08 x 1.08 = 163.3). If a calculator is available that computes powers directly, the nominal value of the third-year loan may be simply determined by raising I plus the rate of inflation to the power of the number of years after the base date (140.0 x 1.082 = 163.3). The calculation of the debt service in nominal terms is given for comparison with the nominal calculation in table 4-24 and with the calculation in real terms later in table 4-26. The nominal debt service is Table 4-26. Debt Service Computation Assuming Equal Installments and Declining Real Burden of Debt Service, 20-Hectare Mixed Farm, Paraguay Project (thousands of 0) Project year Item 1 2 3 4 5 6 7 8 9 10 11 12 13 Loan receipts Real terms' 508 2 107.1 140.0 0 0 0 0 0 0 0 0 0 0 Nominal terms 508.2 115.7 163.3 0 0 0 0 0 0 0 0 0 0 Debt service Nominal terms First-year loan - 66.1 66.1 66.1 66.1 127.1 127.1 127.1 127.1 127.1 127.1 - - Second-year loan - - 15.0 15.0 15.0 15.0 28.9 28.9 28.9 28.9 28.9 28.9 - Third-year loan - - - 21.2 21 2 21.2 21.2 40.8 40.8 40.8 40.8 40.8 40.8 Total - 66.1 81.1 102.3 102.3 163.3 177.2 196.8 196.8 196.8 196.8 69.7 40.8 Net financing 508 2 49.6 82,2 (102 3) (102.3) (163.3) (177.2) (196.8) (196.8) (196.8) (196.8) (69.7) (40.8) Q) Real termsb First-year loan - 61.2 56.7' 52.5c 48 6 86.5 80.1 74.2 68.7 63.6 58.9 - Second-year loan - - 12.9 11.9 11.0c 10.2 18.2 16.9 15.6 14.4c 13.3c 12.3c - Third-year loan - - - 16.9 15.6 14.4 13.3c 23.8 22.0c 20.4 18.9 17.5 16.2 Total - 61.2 69.6 81.3 75.2 111.1 111.6 114.9 106.3 98.4 91.1 29.8 16.2 Net financing 508.2 45.9 70.4 ( 81.3) ( 75.2) (111.1) (111.6) (1149) (106.3) ( 98.4) ( 91.1) (29.8) (16.2) Source: Calculated from tables 4-19 and 4-24. See text for a discussion of compounding factor for 1 for two years, 1.166, to obtain the interest payment how the calculations were made. of 012.9 thousand (115.7 x 0.13 - 1.166 = 12.9). For the first annual install- a. From table 4-24. ment of combined interest and principal repayment for the second-year loan, b. Calculated by dividing each entry in the line, except for the first interest the nominal amount of the loan of 0115.7 thousand is multiplied by the capital installment and the first installment of combined interest and principal repay- recovery factor for six years at 13 percent, 0.250 153, and then divided by the ment, by 1.08. These exceptions are determined by multiplying the nominal compounding factor for 1 for six years, 1.587, to obtain the payment of q18.2 amount of the loan by the interest rate or the capital recovery factor and then thousand (115.7 x 0.250 153 - 1.587 = 18.2). dividing by the compounding factor for 1 for 8 percent (or 1.08") for the c. Calculated as explained in note b; this calculation introduces a slight number of years after the first year of the project. Thus, for the first interest rounding error. Direct calculation using the formulas in the text obtains a payment for the second-year loan, the nominal amount of the loan of 0 115.7 slightly different result. thousand is multiplied by the interest of 13 percent and then divided by the FARM INVESTMENT ANALYSIS 161 calculated in the same manner as the computations in table 4-24 but is based on the nominal amounts of the loan receipts. Thus, for the second- year loan the nominal interest during the grace period would be the nominal value of the loan receipt of 0115.7 thousand multiplied by the interest rate of 13 percent, and this gives an interest payment of 015.0 thousand (115.7 x 0.13 = 15.0). The equal annual installment would be the nominal value of the loan of 0115.7 thousand multiplied by 0.250 153, the capital recovery factor for six years at 13 percent, and this gives an installment of 028.9 (115.7 x 0.250 153 = 28.9). To calculate the debt service in real terms, the nominal amounts must be reduced by the extent of inflation since the loan was made. To do this, the nominal amount is divided by the compounding factor for 1 for the number of years involved. For the first-year loan, the receipt is 0508.2 thousand, and the nominal payment due at the end of year 2 at a 13 percent interest rate is 066.1 thousand (508.2 x 0.13 = 66.1). Since infla- tion is assumed to be 8 percent, the real burden is reduced between the loan receipt at the end of year 1 and the first interest payment at the end of year 2; this reduction makes the real burden of the first interest payment in guaranis of project year 1 only 061.2 thousand (66.1 + 1.08 = 61.2). In year 3, the interest in real terms is again reduced by the amount of the inflation, to 056.7 thousand (61.2 + 1.08 = 56.7). The in- terest in years 4 and 5 is calculated in a similar manner. Repayment of principal combined with interest on the remaining outstanding balance begins in year 6. The equal annual installment in nominal terms that the farmer would pay from years 6 through 11 is determined by multiplying the amount of the loan received, 0508.2 thousand, by the capital recovery factor for six years at 13 percent, 0.250 153. The result is a nominal payment of 0127.1 thousand (508.2 x 0.250 153 = 127.1). Since this is in nominal terms, the real burden is reduced by five years of inflation between the end of year 1, when the loan is received, and the end of year 6, when the first annual installment of interest and principal repayment is made. To do this, the nominal payment of 0127.1 thousand is divided by the compounding factor for 1 for 8 percent for five years to obtain the real burden of the payment at the end of year 6, 086.5 thousand (127.1 + 1.469 328 = 86.5). In year 7 the real burden is again reduced by the amount of the inflation, and this gives a real burden of 080.1 thousand (86.5 + 1.08 = 80.1). The same process is continued through the remaining life of the loan. For the second-year loan, the debt service is again calculated on the basis of the nominal value of the loan, 0115.7 thousand. The nominal interest due during the four-year grace period at the rate of 13 percent, therefore, is 015.0 thousand (115.7 x 0.13 = 15.0). This payment is due, however, in year 3, or two years after the base of the constant value, which is stated in year-1 guaranis. Hence, the nominal value of the interest payment must be reduced by the amount of inflation in both years 2 and 3 by dividing it by the compounding factor for 1 for two years to obtain the real value at the end of year 3, which is 012.9 thousand 162 FINANCIAL ASPECTS OF PROJECT ANALYSIS (15.0 - 1.166 400 = 12.9). The real value of the interest payment in year 4 may be obtained by dividing the interest payment made in year 3 by 1 plus the inflation rate stated in decimal terms, and this gives 011.9 thousand (12.9 + 1.08 = 11.9). The nominal value of the equal annual installment from years 7 through 12 is obtained by multiplying the nominal value of the second-year loan of 0115.7 thousand by 0.250 153, the capital recovery factor for six years at 13 percent; the result is 028.9 thousand. Since this amount is due at the end of the seventh project year, or six years after the base in project year 1, it is divided by the compound- ing factor for 1 for six years to obtain the real value of $18.2 (115.7 x 0.250 153 1.586 874 = 18.2). The real burden of the next in- stallment in year 8 is obtained by dividing the year 7 payment of $18.2 thousand by 1.08; this yields 016.9 thousand (18.2 + 1.08 = 16.9). The same process is continued through the life of the loan. Determining the real burden of each payment is more rapidly and accurately accomplished if an algebraic formula is used instead of the iterative process outlined here. The interest during the grace period may be determined as: L(1 + f) -r Rm- (1+f)m-1 the real burden of the annual installment of combined interest and principal may be determined as: R L(1 + f)" - 'F m (1 + f)m1I in both equations, Rm = real burden of debt service in project year m during grace period R*m = real burden of debt service in project year m during period of annual installment of combined interest and repayment of principal n = project year in which loan is received m = project year in which debt service is made L = real value of loan receipt F = capital recovery factor r = rate of interest paid on loan f = rate of inflation. If a calculator that determines powers directly is not available, the compounding factor for 1 for the appropriate rate and number of years may be used in place of the expressions (1 + f)n - ' and (1 + f)m -'. Although we have by no means given examples of all possible loan terms in this section, the debt service for most other loan terms may be readily calculated following these illustrations. FARM INVESTMENT ANALYSIS 163 Appendix. Herd Projections A basic element in the analysis of agricultural projects that involve a livestock component is a projection of the number of animals. For small animals with a generation interval within the accounting period-for example, poultry-the projections can be done simply by estimating the number of animals that can be maintained with the feed and facilities available. This usually is also the approach for hogs. But for larger animals that take more than one accounting period to mature-includ- ing dairy and beef cattle, sheep, and goats-the projections are usually based on herd buildups that reflect the number of breeding animals, the number of animals born, mortality, and sales. A pattern herd projection is given in table 4-27; it is based on the Paraguay example and is compati- ble with the accounting convention recommended for farm budgets in this book. A herd productivity computation is given in table 4-28. Whether estimated directly or through the use of a more elaborate herd projection, the number of animals forecast is then priced and the value incorporated in the farm budget as was illustrated in the Paraguay example. [This appendix draws heavily from materials especially pre- pared by Meyn, Gittinger, and Schaefer-Kehnert (1980) and Schaefer- Kehnert (1981 a)]. In the text of this chapter (the subsection "Farm Production. Live- stock"), we noted that the purpose of a herd projection is to apply to a herd at the beginning of a project technical coefficients that are estimates of the improvements in management, animal health, and nutrition the project investment will make possible. The herd projection allows esti- mates of future feed requirements, handling facilities, investments, and the productivity of the herd. The herd development is continued until- through natural increase, purchases, or reduced sales-the herd has reached a level at which it can make best use of the available resources. In the same subsection of the text we also noted that, for small farms involving dairy or beef cattle (and to some extent sheep and goats), the problem of divisibility (the reporting of fractional animals) must be resolved. The most satisfactory method of doing this is to take a group of farms-often 100-and to project the herd for all the farms in the group. All calculations in the projections can then be rounded to the nearest whole animal. This avoids having fractional animals in the herd projec- tion, which happens when the technical coefficients are applied to the number of animals in a small herd. The values for purchases and sales for the full 100-farm group are then divided by 100 and entered in the farm budget for the individual farm. In effect, this assumes that on the average a farm will have a given level of purchases and sales. Although this convention is not fully satisfactory, it is better than trying to project herds on the basis of probability or carrying fractional animals in the projection until they aggregate to a whole animal. Herd projections generally are done by someone with a considerable 164 FINANCIAL ASPECTS OF PROJECT ANALYSIS knowledge of livestock production because these projections depend on judgments about feed availability, management improvement, and the like. Thus, most agricultural project analysts would turn to a livestock specialist for assistance with a herd projection, just as they would turn to other agricultural specialists for assistance with such things as crop yields or irrigation construction costs. We will illustrate the methodology of herd projections with the exam- ple of the Paraguay project we have been following in this chapter. This is for a beef production activity on a 20-hectare mixed farm, but with rather minor adaptations it can be used for a dairy herd or, with somewhat more adaptation, for sheep and goats. Terminology and definitions Livestock specialists use a group of special terms that may not be familiar to all agricultural project analysts. A breeding cow is, of course, the mature female of the species that has borne at least one calf; the male is the bull. A calf (plural, calves) is the young animal; its age in these projections is one year and less. Heifers are young females that are older than calves but younger than a predetermined age (in this case, three years) and that have not yet borne calves. Steers are castrated male animals. Culled animals are those taken from the herd because they do not meet performance standards. Carrying capacity refers to the ability of an area of pasture to support animals; it is generally expressed in terms of animal units, a standard measurement of feed. By expressing carrying capacity in animal units, a single measurement for the pasture requirements of the herd is obtained. The standard animal, or one animal unit, in herd projections for cattle is usually a cow of average size in the reference area. Computational conventions A group of simplifying conventions makes calculation of the herd projection less complex and allows it to fit with the accounting conven- tion used for the rest of the farm investment analysis. Analysts vary in the details of the conventions they apply, but the ones we will discuss here, which are used in tables 4-11 and 4-27, are fairly representative, are consistent, and are amenable to computation by hand with a simple calculator. All calculations are rounded to the nearest whole animal. Stock taking for the analysis occurs at the end of the year. Purchases enter the herd at the end of the accounting year, and sales from the herd also occur at the end of the accounting year. Adult mortality is calculated on the basis of the number of animals present at the beginning of the year. For calves, mortality is deducted from the number of calves born during the course of the year. Internal transfers of young animals are accomplished by carrying forward the end-of-year closing stock figure to the opening stock figure of the next higher age category at the beginning of the next year. Transfers of heifers 2-3 years old are added to the number of breeding FARM INVESTMENT ANALYSIS 165 cows at the end of the year, the sum being the closing stock of breeding cows for that year. For bulls and work oxen, the previous end-of-year figures serve as beginning-of-year figures in the following year. The number of bulls in the Paraguay example is taken to be one for each farm, or 100 bulls in the 100-farm herd. The number of bulls required, however, would usually be a function of the number of breeding cows in the herd at the beginning of the year. Additional bulls needed, including those needed for purchased heifers brought into the herd, are assumed to be purchased at the end of the year. There would usually be three to four bulls for 100 breeding cows. For the purpose of the projection, male and female calves are accounted for separately, and the numbers of each are determined by multiplying the number of breeding cows at the begin- ning of the year by half the calving rate. Treating male and female calves separately permits the analyst to apply different technical coefficients to male and female calves, if that reflects reality (the case for calf mortality in East Africa, for example), or to make assumptions that male and female calves will be treated differently (the case in dairy operations where male calves may be sold soon after birth). Culling rates are applied to the number of animals at the beginning of the year. Since herd projection computations can become quite complex, it is important to have good worksheets. A pattern herd projection worksheet that uses data from the Paraguay example is shown in table 4-27. This pattern can rather easily be adapted to the conditions and assumptions of different projects, which vary so widely as to make it impractical to have a standardized worksheet. As these adaptations are made, several principles should be kept in mind so that the worksheet will remain compatible with the accounting convention recommended for farm budgets. Year 1 is reserved for investment (which may extend over more than one year). Production in year I may be reduced by the investment- by plowing grassland to establish improved pasture, for example. In- cremental production begins no earlier than the beginning of year 2; it may begin later if investment takes longer. All purchases and sales, as well as transfers of animals to another category, take place at the end of each year. Thus, purchases that are part of the investment take place at the end of year 1. The first sales generated through incremental produc- tion can occur no earlier than the end of year 2. Heifers retained as breeding cows are transferred at the end of each year. Using brackets to insert the technical coefficients, and boxes to indicate the elements of the preliminary closing stock, are format devices that greatly reduce the likelihood of error when using the worksheets. Technical coefficients The herd projection is built up by applying the technical coefficients to the initial herd until a herd size is reached that just consumes the increased feed to be made available or until some other predetermined limit, such as the size of handling facilities and the like, is reached. The technical coefficients come from field observation and statistics collected by government services as the project is being prepared. 166 FINANCIAL ASPECTS OF PROJECT ANALYSIS For the Paraguay example, the technical coefficients without the proj- ect were determined to be those given in the last part of table 4-27. In general, these improve over the life of the project, in reflection of the analyst's assumption about the effects on the number of animals of project investment and improved management by the farmer. In a herd projection, particular attention to the underlying biological facts must be paid. For example, assume that 30 percent of the bulls in a herd will be replaced with bulls of an improved breed at the end of year 1. Suppose in addition that the age of first calving for heifers in the herd is three to four years. Not until year 5 can introducing better bulls have any effect on herd production. At that time, 30 percent of the steers three to four years old will be heavier, and 30 percent of the heifers giving birth to calves will produce more milk. Very often these facts are neglected; the result is an overoptimistic projection that field results cannot meet. CALVING RATE. The calving rate is the proportion of breeding cows that bear live calves during the year. It is applied to the number of breeding cows in the herd at the beginning of the year. In the pattern worksheet, the number of male and female calves is determined separately by divid- ing the calving rate in half. In the Paraguay example the calving rate is expected to improve from 70 percent at the beginning of the project to 75 percent as a result of improved management. The calving rate of 80 percent during year 3 is the result of purchasing in-calf heifers, which increases the calving rate. Calving rates range from about 50 percent or even less in pastoral herds in areas with one long dry season a year to about 90 percent in well-managed herds in areas with high potential. CALF MORTALITY. The calf mortality is the proportion of live calves born during the year that do not survive to the end of the year. It applies to the number of calves born during the year. In the Paraguay example, it is assumed that improved management will reduce the calf mortality from 10 percent without the project to 5 percent by project year 4. Calf mortality ranges from 40 percent in cattle herds kept under extreme nutritional and climatic stress to less than 3 percent in well-managed beef herds in a favorable environment. Calf losses of 10 percent are common even in well-managed dairy herds. ADULT MORTALITY. The adult mortality is the proportion of animals older than one year that are lost during the year. It is applied to the number of adult animals in each class at the beginning of the year. It is customary to apply the adult mortality rate to all animals above one year old, although losses somewhat higher than average may be expected among first-calf heifers and older cows. In the Paraguay project, adult mortality is already low at 3 percent at the beginning of the project and declines only slightly to 2 percent from year 3 of the project because of better husbandry. Adult mortality ranges from 10 percent to about 2 percent under practical conditions in developing countries. CULLING RATE-BULLS. The culling rate for bulls is the proportion of bulls removed from the herd each year because they fail to meet the FARM INVESTMENT ANALYSIS 167 performance standards or reach a predetermined culling age. It is ap- plied to the number of bulls in the herd at the beginning of the year. In the Paraguay project, the culling rate for bulls would increase slightly from 15 percent to 18 percent. This reflects a decrease in the productive life of the bulls from about 5.6 years assuming a 3 percent mortality rate [1 + (0.15 + 0.03)'= 5.6] to about 5.0 years assuming a 2 percent mortal- ity rate [1 + (0.18 + 0.02) = 5.01. The productive life of a breeding bull cannot be much longer than six years; usually it is two to eight years for temperate-zone cattle and three to nine years for zebu cattle. When genetic improvement is an important part of the management system, farmers will change bulls more frequently than required by the biologi- cal utility of the bull. CULLING RATE-COWS. The culling rate for cows is the proportion of breeding cows removed from the herd each year because they do not meet the performance standards. It is applied to the total number of breeding cows at the beginning of the year. In the Paraguay example, the culling rate rises from 12 percent at the beginning of the project to 15 percent in years 2 and 3, a result of an attempt to improve the perfor- mance standard of the breeding cows. It then drops slightly to 14 percent. At a 14 percent culling rate and a 2 percent mortality rate, the average productive life of a breeding cow would be about 6.2 years [1 + (0.14 + 0.02) = 6.2]. If the age of first calving is taken to be 4 years, this implies that the cows would normally leave the herd at about 10.2 years of age (6.2 + 4 = 10.2). The productive life of cows in a breeding herd ranges from three years in intensive dairy herds to about eight years in beef herds, equivalent to a culling rate of 33 percent and 12 percent respectively, excluding mortality. CULLING RATE-HEIFERS. The culling rate for heifers is the proportion of heifers that are unsuitable for breeding. It is applied to the number of heifers ready for service at the beginning of the year. In the Paraguay example, heifers two to three years old are considered ready for service, but'heifers of one to two years are assumed not to be ready and so are not culled. In this example, the culling rate for heifers rises from 5 percent without the project to 10 percent beginning in year 2. The higher culling reflects tighter performance standards for breeding cows. In most breed- ing herds, from 5 to 10 percent of the heifers would be expected to be unsuitable for breeding. CULLING RATE-WORK OXEN. The culling rate for oxen is the proportion of the oxen removed each year because they do not meet the performance standards. In the Paraguay project, the culling rate is assumed to be 16 percent, reflecting an average working life of some 6.2 years for oxen, about average in most parts of the world (1 + 0.16 = 6.2). RATIO OF BULLS TO BREEDING FEMALES. The percentage of bulls in rela- tion to breeding cows is applied to the number of breeding cows in the herd at the beginning of the year. If in-calf heifers are purchased, addi- (Text resumes on p. 174.) 168 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 4-27. Herd Projection Worksheet, 100 20-Hectare Mixed Farms, Paraguay Project (head) Wtthout development Development year Stable 1,000- 100-farm Item cow herd herd 1 2 3 Breeding bulls Livestock class Opening stock 10 100 100 100 100 - Deaths [%] -- 3 [ 3] - - 3 [ 3] - - 3 [ 3] - - 3 [ 3 ] - - 2 [ 2] -Culls [%]b - 15 [15] - 15 [15] - 30 [30] - 17 [17 ] - 18 [18] + Purchases for existing herd + 18 + 18 + 33 + 20 + 20 Subtotal [%] F [-i =- 00 [-] F 10 [-] = 1 [ - o00 [-i + Purchases for purchased heifers + 0 + 0-+ 0 + 0 + 0 Closing stock =-1- 100 - 100 = 109 - 100 10 Breeding cows Opening stock - 500 - 500 655 800 - Deaths [%]" - 30 [ 3] - 15 [ 3] - 5 [ 3] - 0 [ 3 ] - _16 [ 2] - Culls [%]d - 120 [12] - 6 [2 - 60 [12] -- 98 [15 ] - -120 [15] Subtotal = 5 = 5 = 7Z + Heifer transfers + 150 + 75 + 230 + 263 + 136 Closing stock =1,000 = 500 = 655 = 800 = 800 Female calves Births [%]e 350 [35] 175 [35] 175 [35] 246 [37.5] 320 [40] - Deaths [%] - 35 [10] - 18 [10] - 18 [10] - -25 [10 ]- 2_ [ 8] Closing stock = 77 = 7 flF Heifers 1-2 years Opening stock 35 1 7 I 7 1 7 221 -Deaths [%] - 9 [3]- 5 [ 3] - 5 3] - 5 3 ] - 4 [2] Closing stock = 21 = 21 = 2= Heifers 2-3 years Opening stock 306 152 152 152 152 - Deaths [% -- 9 [ 3] - 5 [ 3] [ 31 - 5 3 ] - 3 [ 2] - Culls [%]9 - l- [ 5] - 8 [ 5] 8 [ 5] --5 [10 ]- ---- [10] Subtotal 2 = 9 = 91 - Sales - 132 - 64 - 0 - 0 -- 0 + Purchases + 0 +- 0 91 +13 + 2 Transfer to cows 150 = 75 230 = 263 = 136 Male calves Births [%] 350 [35] 175 [35] 175 [35] 246 [37.5] 32R [40] - Deaths [%] - 35 [10] - 18 [101 18 [10] - 25 [10 ] - 26 [ 8] Closing stock = 51 = 7- 7 -7 = 1] F 94 Steers 1-2 years Opening stock 315 157 1 7 57 22 - Deaths [%]a -- 9 [ 3] -- 5 3] - -5 3 ] - - 4 [2] Subtotal =306 1 Jl 2171 + Purchases - 0 + 0 + 0 0 + 0 Closing stock = 306 =- 12 152 = 152 = 217 FARM INVESTMENT ANALYSIS 169 Development year Full development Stable 1,000- 4 5 6 Years 7-20 cow herd Livestock class 100 1 00 100 100 100 - 2 [ 2] -.2 [ 2 ] .2.[.2. - 2[ 2 ] --2 [2 ] -- 2 [ 2 18 [18 ] - 18 [18 ] - 18 [18 ] -- [18 ] --__ 18 118 ] - --18 [18] + _ 20 + _ 20 + 20 + + _ 20 + 20 - 00 [ 7- =Io F00 [-0 [-] = [] .~ipr- + _ 0 + __0 + _0 + = 0 = _ 0 = _000 = 100 100 800 _00 800 800 1,000 --6 [ 2] - - 6 [ 2 ] - 62 ] - 2 ] - 6[ 2 ] 20 [ 2] - 2 [14 -.12 [14]- 2 [14 ] - [14]- 2 [14]- 40 [14 ] = 672 = _672 r= 6721 _ 672| 1= 840 + 128 +_128 +- 28 + +--28 + -60 = 800 = _800 = 800 -=. 800 =1,000 300 [37.5] 300 [37.5] 300 [37.5] [37.5] _300 [37.5] _375 [37.5] - _15 [ 5 15 5 5 5] .- - [ 5 . [ 5 ]- _ 19 [ 5 ] 285 .r= 2851 =- 25 = _28 |- 356 294 285 285 285 356 - 26 [2-] [2_6[2] --[2 ] -_6 [2 ] - _ [2 ] F 288 =7=9 =- _ 2-9 =.4 217 28 279 279 349 - ] [.2]--_6 g [2 6 2 2]- __ [ 2 ] - -22 [10 ] -.__29 [10 - 28 [10 ] - [10 ] - 28 [10 1 - 35 [10 1 91 = 253 = 245 = _245 = 307 - 3 - _ 5 -- -- - 17 - 147 + __0 +- 0 + 0 + + __0 + -= = 128 = 128 = 128 ----128 =-_ 160 _300 [37.5) _ 00 [37.5] 300 [37,5] [37.5] 300 [37 5] 375 [37.5] - 15 5 1 - _... [ 5 . -._5 5 ] [ ..].-._]-[ 5 [ 5 ]-][5 ]- - ---[5 ]- 19 [5 ] =285 = 285 = 2 85 285 = 356 294 5 285 285 356 --6[ 2 - 6[2] - 6 [ 2] -- [2] -[ 2] - - [ 2 r= 288 = _291 |= 279 2791 = 349 + -0 +_ 0 + 0 + + -0 + =- 288 = 279 =2 279 = 349 (Table continues on the following pages.) 170 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 4-27 (continued) Without development Development year Stable 1,000- 100-farm Item cow herd herd 1 2 3 Livestock class Steers 2-3 years Opening stock 306 152 152 152 152 - Deaths [%] _ 9 [ 3] -- [ 3] - 5 [ 3] --- [ 3 ] -- 3 [ 2] Closing stock = 7 = 7F 17 = 1471 Steers 3-4 years Opening stock 297 14 4 147 14 - Deaths [%] -9 [ 3] - 4 [ 3] 4 3] - 4 [] -33 -- 3 1 2] Sales = 288 = 143 143 143 = 144 Work oxen Opening stock --- 0 0 200 200 - Deaths [%] _ -- 1 3] --P [ 3] L -3 [ 3] --_ [ 3 ] - 4 [ 2] -Culls [%]' - -- - - 0 [-] - 0 [0] - 32 [16] - 32 [16] + Purchases for existing herd +- - + 0 + 200 + 38 + 36 Closing stock 2 Fq 2q00 Herd totals Total herd stock Opening 2639 3 ,365 1,720 1,993 Prelim. closing 2I1, Over(under)-stocking --- 69 ( 91) ( 308) ( 351) Balancing sales Heifers 2-3 years - 132 --64 - 0 - 0 -- 0 Balancing purchases Heifers 2-3 years +- 0 +- 0 + 91 + 131 + 2 Bulls for above + - + 0 + 0 + 0 + 0 Steers 1-2 years +- 0 ++ 0 ( + _ 0 +- 0 Actual closing =2,639 =1,365 1,720 1,993 =2 271 Carrying capacity (end of year) 1,260 1,720 21170 2,620 Herd growth Herd composition (opening stock) Bulls 100 100 100 100 Breeding cows 50 -N 65 800 Heifers 1-2 years -1- 157 57 221 Heifers 2-3 years 12 152 152 I-2 Steers 1-2 years 157 157 157 221 Steers 2-3 years 12 12 152 152 Steers 3-4 years 147 147 147 147 Work oxen -- 0 2Q 200 Total (animal units) 1,365 1,365 1,720 1,993 Carrying capacity (beginning of year)' - 1260 16 1,72( 2 170 Purchases Bulls 18 33 20 20 Heifers 2-3 years 91 131 2 Steers 1-2 years 0 0 P Work oxen 0 200 38 36 Total 18 324 189 58 FARM INVESTMENT ANALYSIS 171 Development year Full development Stable 1,000- 4 5 6 Years 7-20 cow herd Livestock class --217 --288 --279 -------279 ---349 4.2.] --62] --62] --[2] -6 2] -. 7 [2 273 F= 282 F-73 1112731 F--4 192 13 282 273 342 - [2] -4 [2 ] --6 [2] - - [2] - 52 ] -- 7 2] - 146 = 209 = 276 -= 268 = 335 -- 0 00 -- 0 ---- - 00)- 0 - 4. 2 .] - 4[2] - 4 2] - [2-]-- 4 2] - 4 2] 32 [16 ] - 32 [16 ] - 32 [16 ] - - [16 ] - 32 [16 ] 32 [16 + 36 + 36--- + 3 6. + + 36 + 36 --- --- -Z ------ - --- Herd totals + ... 2,459 + 21 ---9 - .2,50.91 + ,052 20) 20 20 2 - -- 3 _- 125 _- 1-17 - ----- - 1-17 - _147 + 0 + 0 + 0 + + 0 + 0 + - + --- 0 +- p -- ± ---- --- 0 + 0--- + 0 + 60 +,+20 Herd growth 800 0800 800 100 54 5 5 285 217 cn8 u9 o79 29 9485 25 285 21 --28 -- 2 9 - ------2 9----- 20 20 20 --------20----- 0 -- - - 0 - - - - - - - - - 0 -- - - - 0 -- - - - - - 0 - - - --- - --0- - - - - 36 36 -36 36 (Table continues on the follow'ing pages.) 172 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 4-27 (continued) Without development Development year Stable 1,000- 100-farm Item cow herd herd 1 2 3 Herd Growth Sales Culled bulls 1 30 17 18 Culled cows 60 60 98 120 Culled heifers 8 8 15 15 Surplus heifers 2-3 years 64 0 0 0 Steers 1-2 years 0 0 0 0 Steers 3-4 years 143 143 143 144 Culled work oxen --- 0 32 32 Total 290 241 305 329 Technical coefficients (percent) Calving rate 70 70 751 80Y Calf mortality 10 10 10 8 Adult mortality 3 3 3 2 Culling rate, bulls 15 30 17 18 Culling rate, cows 12 12 15 15 Culling rate, heifers 5 5 10 10 Culling rate, work oxen - 0 16 16 Bulls/breeding femaleSk Carrying capacity (per hectare, end of year)' 1.2 1 6 2 1 2 5 Without-development area carryng capacity 1,260 - 100 1,160 _ =_ - L=0 457 Without-development pasture 2,639 - 100 2,539 requrrement of stable 1,000-cow herd + followers Note: Brackets indicate technical coefficients; parentheses indicate negative numbers; boxes indicate elements of preliminary closing stock. The blank column before the columns under the heading "full development" is included because the analyst will not know in advance just how many years it will take to achieve full development. The worksheet should include a generous number of columns under the heading "development year" even though at the end of the herd computation some of these will be unused. Source: Same as table 4-11. a. Adult mortality rate. e. One-half of calving rate. b. Culling rate of bulls. f. Calf mortality rate. c. Bulls/breeding females rate. g. Culling rate of heifers. d. Culling rate of cows. h Culling rate for work oxen. FARM INVESTMENT ANALYSIS 173 Development year Full development Stable 1,000- 4 5 6 Years 7-20 cow herd Herd Growth 112 -- 12 - - 0 2 ----- --112----- 22 2928 28 ---63 ---125 ---117 ----- --117-- 146 209 276 268 32 32 --- 2 - -------32----- 393 525 53 5 Technical coefficients (percent) 75 75 75 75 75 5 5 5 5 5 ----- 2 2 2 2 2 ---- 18 18 18 18 18 14 14 14 14 14 10 10 10 10 10 16 16 16 16 16 2.5 2.5 25 2.5 2 5 With-development area cartng capacity 2,620 - 100 -200 2,320 084 With-development pasture 3,052 - 100 - 200 2,752 requirement of stable 1,000-cow herd + folloivers i. In animal units. The carrying capacity at the beginning of the year is determined by multiplying the animal units per farm at the end of the previous year given in table 4-10 by the 100 farms in the model. Similarly, the carrying capacity at the end of the year is determined by multiplying the animal units per farm at the end of the year given in table 4-10 by the 100 farms in the model. The carrying capacity per hectare at the end of the year is determined by dividing the animal units per farm by the 10.5 hectares of pasture on each farm; it is thus a weighted average of natural and improved pasture. j. Represents a weighted average between the calving rate of breeding cows in the existing herd, which is 70 percent, and that of purchased bred heifers, which is nearly 100 percent. k. Note that in this project a minimum of one bull per farm is assumed, or a minimum of 100 bulls on 100 farms. The number of bulls per 100 breeding females would usually be three to four for all years. 174 FINANCIAL ASPECTS OF PROJECT ANALYSIS tional bulls will be needed; the number is determined by multiplying the number of heifers by the bulls/breeding females percentage. In the Para- guay example, there is an exceptionally high number of bulls in the herd because it is assumed that each farm will keep one bull for breeding. The biological requirement for the proportion of bulls in relation to breeding cows would be on the order of 3 to 4 percent in ranch herds and 2 to 3 percent in more intensive operations. In a smallholder district it would make sense for farmers to form groups or cooperatives to share the use of bulls, especially in dairy herds where detection of cows in heat is rela- tively easy. In the long term, dairy herds would be expected to be given access to an artificial insemination service, and then no bulls would be required on the individual farms. Animal units The size of a beef or dairy herd should be related to the feed available. This availability is denominated in animal units, a standardized measurement that permits comparison between herds and between the herd size and feed availability. When the major source of feed is to be pasture, as is the case in the Paraguay example, the total feed consump- tion of the herd can then be fitted to the grazing anticipated to be available. By converting grazing animals into animal units, a better measurement for feed requirements is obtained than is possible by using the total number of animals alone. The variation in feed consumption between age and sex groups makes this conversion desirable. It is also possible to permit aggregation with other animal species using the same grazing resource. Use of animal units is not uniform in contemporary practice among livestock specialists. Rather, it is common to take a breeding cow, gener- ally without a calf, as the unit and to relate other animals to that base. Thus, the basic animal unit in most developing countries would probably be something on the order of a 250-kilogram breeding cow. In areas where the average breeding cow is heavier, the animal unit used in computation might be the heavier cow. For a beef herd fed mainly on pasture, estimates of carrying capacity are very approximate, and so a short-cut computation of animal units is used. This has been incorporated in the Paraguay herd projection in table 4-27. The total of animal units is taken to be the number of adult animals in the herd (that is, the total number of animals less the calves). Although this introduces some distortion into the estimate of the animal units, it is well within the margin of error of estimating carrying capacity and greatly facilitates the herd projection. Many analysts, however, prefer to assign different animal unit weights to different classes of animals according to the different consumption of each class. Breeding cows remain the basic unit. A set of conversion factors commonly employed assigns 1.2 animal units to bulls, 1.0 animal units to breeding cows, 0.3 animal units to calves of zero to one year, 0.6 animal units to cattle of one FARM INVESTMENT ANALYSIS 175 to two years, 0.8 animal units to cattle of two to three years, 1.0 animal units to cattle over three years, and 1.2 animal units to work oxen. For projections of sheep and goat herds, the reference animal may be assumed to be equivalent to one-sixth, or 0.17, of an animal unit. (Recall that the animal unit is based on the average breeding cow in the area. The relation between body weight and animal units is not proportional be- tween animals of different weights because smaller animals consume proportionately more feed per unit of body weight. The factor is also influenced by the different grazing habits of sheep and goats in contrast with those of cattle.) Thus, ewes or does would be 0.17 animal units; lambs and kids between birth and six months, 0.09 animal units; sheep and goats over six months, 0.17 animal units; and rams or billy goats, 0.20 animal units. Camel cows may be converted to 1.5 animal units and buffalo cows to 1.8 animal units, with the different age groups bearing the same proportionate number of animal units as they would in a cattle herd. Because of the low accuracy of carrying capacity estimates, an over- or understocking of 10 percent is permissible in herd projections, although as the herd buildup proceeds the stocking rate would be held within a narrower range until the number of breeding females in the stable herd with the project has been reached. Determining the stable herd Before turning to the computation of the herd projection itself, there are several ground rules to note. In making the projection, we will round the number of breeding cows without the project and at full development to a multiple of the number of farms in the model. This makes it possible to speak of a single farm as having a whole number of breeding cows. Thus, we can tell from table 4-27 that the 20-hectare mixed farm has five breeding cows without the project, and this increases to eight at full development of the project. Also, as the herd buildup proceeds, we will not allow the number of breeding cows in any year to exceed the number at full development. Thus, at the end of year 2, which is the beginning of year 3, the number of breeding cows is not allowed to exceed 800-the number at full development-even though there would be some addi- tional carrying capacity available. Finally, in following the Paraguay example, we will conform to the analyst's assumption that no feeder steers-steers purchased from outside the herd, to be fattened for sale- would be available. In other beef herd projections, however, purchases of feeder steers might be used to utilize any excess carrying capacity. To begin our herd projection, we prepare a worksheet similar to that shown in table 4-27 and insert the relevant technical coefficients within the brackets. By using this format, there is less danger of applying erroneous technical coefficients. Note the boxes for some numbers; this device also facilitates the computation and should be included in the worksheet prepared. Since it is not known in advance just how many 176 FINANCIAL ASPECTS OF PROJECT ANALYSIS years it will take for the herd to stabilize at the full development con- figuration, the worksheet should contain a generous number of columns even though at the end of the computation there will be unused columns (such as the last, blank column under the heading "development year" in table 4-27). The first task in preparing the herd buildup is to determine the size of the stable herd without the project and at full project development. First we will determine what would be a stable herd for 1,000 breeding cows and the number of animal units such a stable herd would consume. We will then take the ratio between the 1,000-cow herd consumption and the carrying capacity of 100 farms in the project and adjust the 1,000-cow herd to that capacity. (In some instances, the herd will not be stable at the beginning of the project. In that case, the technical coefficients observed in the field will be applied to the 1,000-cow herd at the begin- ning of the project.) This process of determining the stable herd can be illustrated by following the computation for the stable herd at full development. We begin by working through the last column of the herd projection work- sheet in table 4-27. We calculate the deaths and culls for 100 bulls by multiplying the opening stock by the relevant technical coefficients (transferred to the brackets from the bottom of the table). For the 100 bulls there would be a 2 percent mortality and an 18 percent culling rate, so that 80 bulls would remain after applying the coefficients [100 - (100 x 0.02) - (100 x 0.18) = 80]. To bring the total number of bulls back to the opening stock position of 100, we thus would need to purchase 20 bulls (100 - 80 = 20). The opening stock position of 100 bulls, then, is entered on the subtotal box. Since the herd is stable, no heifers would be purchased, and the closing stock number of 100 may be entered directly. (Were this not a model for smallholders but for one large 1,000-cow herd, the number of bulls in the opening and closing stock would be determined by multiplying the number of breeding cows at the beginning of the year by the bulls/breeding cows percentage.) Turning to the breeding cows, we subtract the 20 deaths and the 140 culls from the opening stock of 1,000 cows to obtain the 840 breeding cows entered in the subtotal box [1,000 - (1,000 x 0.02) - (1,000 x 0.14) = 840]. That means we will have to transfer 160 heifers to the breeding cow herd at the end of the year to bring the closing stock back up to 1,000 (1,000 - 840 = 160). Proceeding to the female calves, we multiply the 1,000 cows in the herd at the beginning of the year by 37.5 percent, which is one half the calving rate of 75 percent (75 + 2 = 37.5), to obtain the 375 births (1,000 x 0.375 = 375). Now we multiply 375 by the calf mortality rate of 5 percent to obtain the loss of female calves, which is 19. This is subtracted from 375 to reach the closing stock number of 356 [375 - (375 x 0.05) = 356]. We enter the 356 closing stock female calves as the opening stock number for heifers one to two years old. We multiply 356 by the adult FARM INVESTMENT ANALYSIS 177 mortality rate of 2 percent and subtract the result from the opening stock figure, 356, to obtain 349 [356 - (356 x 0.02) = 349]. We enter the closing stock number of 349 heifers of one to two years as the opening stock number for heifers of two to three years, then multiply it by the adult mortality rate of 2 percent and the culling rate for heifers of 10 percent. The results are then subtracted from the opening stock number to obtain the subtotal for heifers of two to three years of 307 [349 - (349 x 0.02) - (349 x 0.10) = 307]. We enter the 160 end-of-year transfers that will be needed to bring the closing stock of breeding cows to 1,000 (as we calculated at the top of the column) and subtract this from the 307 subtotal of heifers two to three years old to obtain the sales of 147 animals (307 - 160 = 147). For male calves, we multiply the opening stock of 1,000 cows in the herd at the beginning of the year by 37.5 percent, which is one half the calving rate of 75 percent (75 + 2 = 37.5), to obtain the 375 births (1,000 x 0.375 = 375). Applying the calf mortality of 5 percent we obtain the loss of 19 calves (375 x 0.05 = 19), which is subtracted from the births to obtain the closing stock entry of 356 [375 - 19 = 356]. The closing stock of male calves becomes the opening stock of steers one to two years old, of which 2 percent are lost through mortality, for a closing stock of 349 [356 - (356 x 0.02) = 349]. The closing stock number of 349 steers one to two years old becomes the opening stock number for steers two to three years old. We multiply 349 by the 2 percent adult mortality rate and subtract the result, 7, to obtain the closing stock figure of 342 [349 - (349 x 0.02) = 342]. The closing stock of steers two to three years old becomes the opening stock number for steers three to four years old. This number is, in turn, reduced by the 2 percent adult mortality rate; the remainder becomes the 335 steers three to four years old that are sold [342 - (342 x 0.02) = 3351. In the Paraguay example, we know the closing stock of oxen will be 200. We enter this closing stock figure as the opening stock figure. We multiply the opening stock figure of 200 oxen by the adult mortality rate of 2 percent and the culling rate of 16 percent to obtain the number of oxen that will be taken from the herd. In this case, that number is 36; 36 oxen must be purchased to bring the closing stock back to 200 [(200 x 0.02) + (200 x 0.16) = 36; 200 - 36 + 36 = 200]. Proceeding to the herd totals, we sum the opening stock figures (recall that calves are not part of the opening stock-they are born during the year) to obtain the opening stock of 3,052. Our preliminary closing stock figure of 3,199 is obtained by adding all the figures in the boxes. The difference is 147, which is the number of heifers sold, so that figure may be entered under balancing sales to bring the actual closing stock down to 3,052 animals. The number of animal units that the stable 1,000-cow herd will con- sume is estimated by taking the number of adult animals, which, conve- niently, is also the opening stock of 3,052. 178 FINANCIAL ASPECTS OF PROJECT ANALYSIS We know from the pasture production given in table 4-10 that at full development each farm will have a carrying capacity of 26.2 animal units, so the total carrying capacity of 100 farms will be 2,620 animal units. Now, in order to obtain the number of breeding cows that would be needed in a stable herd that consumes 2,620 animal units, we simply determine the ratio of available carrying capacity to the animal units needed by the 1,000-cow herd and apply that ratio to 1,000 to obtain the number of breeding cows in the stable herd at full development that will consume 2,620 animal units. Recall that there will be 100 bulls and 200 oxen in both the stable 1,000-cow herd and the full-development herd, so we must subtract the consumption of those animals before determining the ratio. Now we obtain the ratio as shown in table 4-27 and determine that it is 0.843 [(2,620 - 100 - 200) + (3,052 - 100 - 200) = 0.843]. Multiplying the 1,000-cow herd by this ratio gives us 843 breeding cows (1,000 x 0.843 = 843). Most analysts would prefer to round this to the nearest multiple of the number of farms in the model so that fractional animals are not reported for the individual farm, at least if the result of rounding to the nearest multiple keeps the total animal units within -L 10 percent of the carrying capacity. In the Paraguay example, the rounded number would be 800 breeding cows. Now, to determine the stable full-development herd we start with 800 breeding cows and work out the stable herd in exactly the same manner as we did for the 1,000-cow herd. The result, tabulated in table 4-27, gives a total herd of 2,501 animals at the beginning of each year, which has a total animal unit consumption of 2,501 using our short-cut calculation. This results in an understocking of 5 percent, but that is sufficiently within the ± 10 percent margin that good practice allows. Exactly the same procedure would be followed to determine the stable herd without development; we thus would have a stable herd for 100 farms at the beginning of the project and at full development. The next step is to calculate the growth of the herd from the without-project stable herd to the full-development stable herd. The procedure we have suggested for determining a stable herd can also be done algebraically in one step. A formula can be set up in which the unknown is the number of breeding cows, since the number of all other classes of animals (except bulls and oxen) derive from it. Only those classes of animals in the herd at the beginning of the year are included in the formula. There would be breeding cows, animals one to two years old, animals two to three years old, steers three to four years old, bulls, and oxen. (Of course, all calves would have become animals of one to two years at the beginning of the year.) In most instances, the number of bulls would be dependent upon the number of breeding cows, but in the Paraguay example the number is fixed at 100. Similarly, the number of oxen is fixed at 200. The formula would then look as follows: FARM INVESTMENT ANALYSIS 179 Breeding cows 1-2-year animals 2-3-year animals x + (0.75)(0.95)x + (0.75)(0.95)(0.98)x 3-4-year steers Bulls Oxen + (0.75)(0.5)(0.95)(0.98)(0.98)x + 100 + 200 Carrying capacity = 2,620. In the formula, x is the unknown number of breeding cows. The first element in each expression where the unknown appears is the calving rate. For steers three to four years old, the next element is the 50 percent of the calves born that are male. The remaining elements represent the survival rate; that is, 1 less the mortality rate for each year of age. For steers three to four years old, for example, the survival rate of calves in year I is 0.95 (1 - 0.05 = 0.95), and in years 2 and 3 it is 0.98 (1 - 0.02 = 0.98). For bulls and oxen the number is fixed, so we enter the number of animals in the herd at the beginning of the year. The carrying capacity, of course, comes from the full-development carrying capacity of a 20-hectare mixed farm multiplied by 100. When we solve the for- mula, we obtain 843 breeding cows-exactly the same number we deter- mined by the ratio method described earlier. This would be rounded to 800 animals, and the result put in the subtotal for breeding cows in the herd projection worksheet (table 4-27). The stable full-development herd would then be calculated by applying the technical coefficients as we have discussed. If the herd turns out not to be stable when this is done, there is an error in formulating or in solving the formula. (If different classes of animals were to be assigned weights, in contrast with the short-cut of assigning one animal unit to each adult animal, then each expression in the formula would be multiplied by the appropriate animal unit weight.) Tracing the herd growth Once the stable herd at the beginning of the project and the stable herd at full development have been determined, the herd growth can be traced from the beginning of the project to the state of full development. To do this, we may continue to use the pattern worksheet laid out in table 4-27. First, we transfer all closing stock numbers of the without- project stable herd to the appropriate blanks in year 1. The closing stock of 100 bulls in the 100-farm stable herd without the project becomes the opening stock of bulls in year 1; the closing stock of 500 breeding cows becomes the opening stock of breeding cows in year 1; the 157 female calves becomes the opening stock of heifers one to two years old; the closing stock of 147 end-of-year steers two to three years old becomes the opening stock of steers three to four years old; and so forth. Then we trace 180 FINANCIAL ASPECTS OF PROJECT ANALYSIS the effect of the various technical coefficients that act on the herd by the same procedure used in determining the stable herd for the bulls, breed- ing cows, heifers, steers, and oxen. For heifers two to three years old, we work down only to the subtotal box, since purchases and sales of these animals are balancing transactions. If we were determining the number of bulls on the basis of the bulls/breeding females percentage, we would work only to the subtotal box for bulls. Since the number of bulls is fixed at well above the bulls/breeding females percentage in the Paraguay example, the subtotal directly becomes the closing stock number. Simi- larly, if the plan for the herd growth called for purchase and sale of feeder steers, we would work only to the subtotal box for the steers. In the Paraguay project, since there is no purchase or sale of feeder steers, the subtotal in all years becomes the closing stock figure. In year 1, 200 oxen will be purchased and added to the 100-farm herd, so they show as purchases. Because all purchases are assumed to occur at the end of the year, there are no deaths or culls, and all 200 oxen remain at the end of the year. Losses and culls will, of course, be calculated from year 2 onward. Next we total the opening stock (which, of course, includes no calves), which comes to 1,365 animals, and enter that in the herd total. Then we add all the figures in the boxes to arrive at the preliminary closing stock of 1,629. Comparing that with the carrying capacity at the end of the year of 1,720 animal units, we find we are understocked by 91 animal units. That permits us to purchase 91 heifers of two to three years to make our actual closing stock 1,720 adult animals and thus exactly match the carrying capacity. Then we may enter the 91 heifers in the table as purchases and complete the column by calculating the transfers to cows of 230 animals. Now we can complete the herd summary for year 1, totaling the opening stock herd composition, the purchases, and the sales, and noting the carrying capacity. This same procedure is then repeated for each year until the herd reaches the stable full-development configuration. In the Paraguay proj- ect, this occurs in year 7. Note the effect of the decision rule of not allowing the number of breeding cows to exceed the full-development number of 800. This means that after year 3 there are no more purchases of heifers two to three years old, and excess heifers two to three years old are sold beginning in year 4. For example, we may trace through the calculations in detail for year 3. The opening stock of bulls is 100 (the closing stock in year 2), of which 2 percent are lost to mortality and 18 percent are culled. Eighty therefore remain, and 20 must be purchased to bring the subtotal back to 100, which then directly becomes the closing stock [100 - (100 x 0.02) - (100 x 0.18) + 20 = 100]. The opening stock of breeding cows is 800, a figure that was reached during year 2 and that our decision rule prevents us from exceeding. Of these, 2 percent are lost to mortality and 15 percent are culled, for an entry in the subtotal box of 664 [800 - (800 x 0.02) - (800 x 0.15) = 664]. FARM INVESTMENT ANALYSIS 181 To bring the closing stock back to 800, we need 136 heifer transfers (800 - 664 = 136). There are 320 female calves born, determined by applying half the calving rate of 80 percent to the opening stock of breeding cows (800 x 0.80 + 2 = 320). Of these, 8 percent die, leaving a closing stock of 294 [320 - (320 x 0.08) = 294]. The 221 opening stock of heifers one to two years old was the closing stock in year 2 of female calves. Two percent are lost to mortality, leaving 217 as the closing stock [221 - (221 x 0.02) = 217]. The 152 heifers two to three years old are the closing stock of heifers one to two years old in year 2. Mortality is 2 percent, or 3 animals, and culling is 10 percent, or 15 animals, leaving 134 heifers to be entered as the subtotal [152 - (152 x 0.02) - (152 x 0.10) = 134]. We skip heifer purchases and sales for the moment but will return to them after we know the situation of the balancing transactions. The 320 male calves born represent half the calving rate of 80 percent applied to the 800 breeding cattle in the opening stock (800 x 0.8 + 2 = 320). Applying the 8 percent calf mortality rate reduces these by 26 animals, to 294 [320 - (320 x 0.08) = 294]. The 221 opening stock of steers one to two years old transferred from the closing stock of male calves in year 2 is reduced by the 2 percent mortality rate to give a subtotal of 217 animals; this is also the closing stock, since we are assuming there will be no steers one to two years old available for purchase as a balancing transaction [221 - (221 x 0.02) = 217]. Similarly, the opening stock of 152 steers two to three years old (which is the closing stock in year 2 of steers one to two years old) is reduced by the 2 percent adult mortality rate to a closing stock figure of 149 [152 - (152 x 0.02) = 149]. The 147 opening stock of steers three to four years old transferred from the year-2 closing stock of steers two to three years old is also reduced by the 2 percent mortality, leaving 144 steers three to four years old for sale [147 - (147 x 0.02) = 144]. The work oxen open with 200 animals; 2 percent, or 4 animals, are lost to mortality, and 16 percent, or 32 animals, are culled. This leaves 164 work animals, so 36 must be purchased to bring the closing stock up to 200 again (200 - 4 - 32 + 36 = 200). Turning to the herd totals, the opening stock is 1,993 animals, the same as the closing stock in year 2. Adding the numbers in the boxes, we reach the preliminary closing stock of 2,269. When we compare this with the carrying capacity at the end of year 3 which is 2,620 animal units, we find an understocking of 351 animal units. This means we would have the pasture resources to permit feeding as many as 351 purchased animals. But we only need 2 animals to bring the number of heifer transfers up to the 136 needed to restore the number of breeding cows to the maximum allowable of 800, and 136 can thus be put in the entry for transfer to breeding cows under heifers two to three years old. Since we cannot purchase feeder steers to utilize the remaining available carrying capac- Table 4-28. Computation of Herd Productivity, 100 20-Hectare Mixed Farms, Paraguay Project (animal units) Development year Full Without development Item development 1 2 3 4 5 6 (years 7-20) Opening stock' 1,365 1,365 1.520 1,793 2,071 2,259 2,310 2,310 Off-take Sales' 290 241 273 297 361 493 551 543 + Home consumptionb + 0 + 0 + 0 + 0 + 0 + 0 + 0 + 0 -Purchases' - 18 - 124 - 151 - 22 - 20 - 20 - 20 - 20 Total 272 117 122 275 341 473 531 523 Rate(%) 20 9 8 15 16 21 23 23 Herd growth Following-year opening stock' 1,365 1,520 1,793 2,071 2,259 2,310 2,310 2,310 Growth 0 155 273 278 188 51 0 0 Rate (%) 0 11 18 16 9 2 0 0 Herd productivity' Rate (%) 20 20 26 31 25 23 23 23 Source- Calculated from table 4-24. computation is done for 100 farms and the values carried to the individual a Work oxen are omitted to give a better estimate of the productivity of the model farm budgets Were the accounts structured to note home consumption beef herd separately, it would have to be included in the productivity computation b. In the Paraguay example, no home consumption is assumed because the c. The sum of the off-take rate plus the herd growth rate. FARM INVESTMENT ANALYSIS 183 ity, the closing stock for the total herd of 2,271 remains well below the carrying capacity of 2,620. The results of our calculations can now be transferred to the summary table. Once we have the worksheets completed, the results are summarized in the herd composition, purchases, and sales table along the lines of table 4-11. The herd composition at the beginning of the year, the pur- chases, the sales including culls, and the technical coefficients are trans- ferred from the worksheet to the table. The details of the computation need not be reported in a project report. Rather, the worksheets can be made available to anyone who wishes to review the computation. It is convenient to have a summary measure of herd productivity. Table 4-28 shows one such measure. It is the sum of the off-take rate and the herd growth rate. It shows that the herd productivity grows from 20 percent without the project to 23 percent with the project. These two figures are transferred to the herd computation, purchases, and sales summary in table 4-11. The interim figures during the development period are tabulated in table 4-28, but they may be misleading because of distortions arising from the dynamics of the herd growth, and so are better not transferred to the summary. Machine computation Calculations of herd projection, clearly, become very complex and tedious and are easily subject to arithmetic errors. As a result, some analysts have turned to machines for help. Espadas (1977) has prepared a program for a programmable calculator, and several programs are avail- able for a full computer [see that of Powers (1975)]. Using machines for herd projections has the advantage not only of increasing accuracy but of making it possible to do sensitivity analyses easily by changing basic assumptions and technical coefficients-something that is almost never done in practice, when the analyst must rely on computation by hand. Feed budget In projects where the major feed supply is to be pasture-as in the Paraguay Livestock and Agricultural Development Project we have been following in this chapter-the farm feed requirement and production are appropriately dealt with by estimating the carrying capacity and thus the total animal units that will be available from the pasture, always keeping in mind the rather low accuracy of those estimates. But in projects where more intensive livestock production is planned-such as poultry, pigs, dairy cattle, and feedlot beef-a more accurate feed budget for each pattern farm should be prepared. This will compare the feed requirement with the on-farm production and estimate the quantities the farmer must purchase or can sell. The feed requirement and produc- tion estimate is also needed to assess how farm production patterns may be changed to produce sufficient feed or to utilize excess feed. These estimates will require a considerable knowledge of livestock production, Table 4-29. Feeding Period and Daily Ration, 20-Hectare Mixed Farm, Paraguay Project Daily ration Protein Feeding period Number Number of Whole Soy- Sun- Chick concen- Manioc Maize Soy of feeding milk Maize beans flower mash trate tubers stover hay Livestock class From To Days animals days (liters) (kg) (kg) (kg) (kg) (kg) (kg) (kg) (kg) Cattle Dairy cows I May 30 Sept 152 8 1,216 - 1.0 10 - - - - 5.0 30 Calves, rearing la - - 84 3 252 30 - - - - - - - - Calves, rearing 2b - - 160 3 480 - 05 0.5 - - - - - 1.0 Steers - - - - - - - - - - - - - - Heifers - - - - -- - - - - - - - - - ! Bulls I May 30 Sept 152 1 152 - 10 1.0 - - - - 6.0 3.0 Work oxen I Sept 30 Nov 90 2 180 - 10 1.0 - - - - 6.0 30 Pigs Dry sows - - 100 5 500 - 0.5 05 05 - - 3.0 - - Suckling sows - - 265 5 1,325 - 20 10 0.5 - - 2.0 - - Boars I Jan 31 Dec 365 1 365 - 10 05 05 - - 30 - - Pigletsc - - 56 72 4,032 - 0.3 0.2 - - 0.1 - - - Fattening pigs - - 150 70 10,500 - 0.5 0.5 - - 05 60 - - Poultry Chicksd - - 56 20 1,120 - - - - 0036 - - - - Growers" - - 112 20 2,240 - - - - 0080 - - - - Layers' I Jan 31 Dec 365 20 7,300 - 006 - - - 0.06 - - - Source: Calculated from assumptions based on tables 4-4, 4-10, and 4-11 c. Rearing period on concentrates fifty-six days starting after four days a Rearing period with milk twelve weeks, individual dates vary. Three d. Rearing period twenty-four weeks, consumption per head 2 kilograms liters a day whole milk during first twelve weeks chick mash and 9 kilograms grower mash b Rearing period on concentrates 160 days starting after three weeks e. Home-prepared ration. FARM INVESTMENT ANALYSIS 185 and the project analyst probably will wish to consult livestock specialists when he prepares estimates of feed supply and use. Preparation of a feed requirement and production estimate can be illustrated by adapting the Paraguay example. We will work only with the full-development period, years 7-20. Note, however, that the esti- mate was not part of the original project analysis because it was assumed that farmers would depend primarily upon pasture for feed. As a result, the example for feed requirement and production only partially articu- lates with the other illustrations in this chapter that fully interlink with one another and were drawn directly from the Paraguay project. FEEDING PERIOD AND DAILY RATION. To prepare a feed requirement and production estimate, we may begin by estimating the feeding period and daily ration for each class of livestock on the farm, as shown in table 4-29. For purposes of illustration, we may assume that the 20-hectare mixed farm in the Paraguay example will produce beef and dairy cattle, pigs, and poultry (this, of course, was not in fact the case in the project from which this example was drawn). We enter each class of livestock on the farm that receives supplementary feeding in addition to grazing for part or all of the year. Steers and heifers that are fed entirely from pasture are included in the illustration for the sake of completeness. The feeding period for a constant ration for each group that is to receive sup- plementary feed is shown along with the number of animals in the class. When there are two quite different kinds of ration that are to be fed a class of livestock, they are shown separately, as is the case for calves. Multiplying the number of days each animal is to be fed by the number of animals gives the number of "feeding days" for each class. For dairy cows, for example, this comes to 1,216 days (152 x 8 = 1,216). The com- position of each daily ration is shown. The order of the major components of the ration is considered to be a good one: milk, cereals, oilseeds, milling and agroindustrial by-products, concentrates, tubers, and roughage. FEED REQUIREMENT AND PRODUCTION. From the estimates for the feeding period and the daily ration, the annual feed requirement for each class of animals may be determined as shown in table 4-30. (As in the main text of the chapter, principal categories from the pattern table are shown in italic type.) For dairy cows, for example, we know from table 4-29 that each animal is to receive 5.0 kilograms daily of maize stover (chopped stalks and cobs), and there are 1,216 feeding days each year. As a result, the annual need for stover for dairy cattle can be estimated at 6.08 tons (1,216 x 5 - 1,000 = 6.08). Adding the requirement for each class gives the total requirement. The on-farm feed production would be taken from the crop and pasture production given in table 4-10. (Since crop by- products such as maize stover and soy hay are not included in table 4-10, they are calculated as indicated in the notes to table 4-30.) This can now be compared with the total requirement to estimate the feed purchase and sale. For example, the total requirement for sunflower is 1.09 tons, where- Table 4-30. Feed Requirement and Production, 20-Hectare Mixed Farm, Paraguay Project (tons) Chick Protein Whole Soy- Sun- grower concen- Manioc Maize Soy Item milk Maize beans flower mash trate tubers stover hay Feed requirement Cattle Dairy cows - 1 22 1 22 - - - - 608 3.65 Calves, rearing I (liters) 756 - - - - - - - - Calves, rearing 2 - 0 24 0.24 - - - - - 048 Steers - - - - - - - - - Heifers - - - - - - - - - Bulls - 0 15 0 15 - - - - 0.91 046 Work oxen - 018 0 18 - - - - 108 054 Pigs Dry sows - 025 025 0.25 - - 1.50 - - Suckling sows - 2.65 1.32 066 - - 265 - - Boars - 036 0 18 0.18 - - 1 10 - - Piglets - 1.21 0.81 - - 040 - - - Fattening pigs - 5 25 5 25 - - 5.25 63.00 - - Poultry Chicks - - - - 0.04 - - - - Growers - - - - 0.18 - - - - Layers - 0.44 - - - 044 - - - Total requirement 756 11 95 960 1.09 022 6.09 6825 807 5.13 On-farm feed productiona - 0.70 540 360 - - 1200 1.00b 5 40' Feed purchase and sale Surplus for sale - - - 251 - - - - 027 Quantity to be purchased - 11 25 4.20 - 0 22 609 56 25 7 07 - Source: Calculated from tables 4-10 and 4-29 b Assumes 2 tons of maize stover production per hectare from 0.5 hectares a. From table 4-10. c. Assumes 1.8 tons of soy hay production per hectare from 3 0 hectares. FARM INVESTMENT ANALYSIS 187 as the total production is estimated to be 3.60 tons; there is therefore a surplus for sale of 2.51 tons (3.60 - 1.09 = 2.51). But 11.95 tons of maize are estimated to be required, and only 0.7 ton will be produced; the quantity to be purchased of maize is therefore 11.25 tons (11.95 - 0.70 = 11.25). The estimated surplus or purchase valued at farm- gate prices would then be carried through to the farm budget. 藝久 5 Financial Analysis of Processing Industries AGRICULTURAL PROJECTS frequently include processing facilities such as packing sheds, preserving and canning plants, oil extraction mills, rice mills, sugar refineries, and the like. For these agriculturally based indus- tries (or "agroindustries"), we must project and analyze financial state- ments to judge efficiency, incentive, creditworthiness, and liquidity and to determine the costs and benefits that are to be included in the overall project. Whether such enterprises are publicly or privately owned, there is the same need to analyze their financial structure. Analyzing and projecting financial statements for these enterprises requires a considerable, specialized expertise that those responsible for agricultural project analysis often do not possess. The purpose of this chapter is thus twofold. First, for those who do not consider themselves experts in financial analysis, it provides an analytical pattern to apply to less complex agricultural industries included in their projects. Second, for an accountant or financial analyst, it indicates the kinds of financial information needed for agricultural projects. Then, when a project analyst turns to these specialists for their help, they can adapt the pattern formats in this chapter to develop appropriate financial state- ments for a particular agricultural project. Facing page: Harvesting coffee in the Kenya highlands. 189 190 FINANCIAL ASPECTS OF PROJECT ANALYSIS The treatment here of these issues is necessarily brief; project analysts may want to consult Upper (1979), a collection of teaching materials that expands many of the elements only summarized here. Much of the fol- lowing discussion is drawn directly from these materials. Those in- terested in more detail may also wish to consult a standard accounting textbook such as Niswonger and Fess (1977), which uses the U.S. accounting conventions, or Bigg and Perrins (1971), which uses the Brit- ish conventions. In the discussion here, we will generally follow the accounting conventions of U.S. practice and note some of the important ways that it differs from British practice. Both conventions, however, are essentially identical; differences are almost entirely limited to conven- tions of presentation and to a few specialized terms used for accounting concepts. We will illustrate the kinds of accounts that are appropriate for the financial analysis of a processing enterprise that is a part of an agricul- tural project with examples adapted from the sugar mill included in the South Nyanza Sugar Project in Kenya. We will reproduce the figures for selected years; the original accounts were projected for sixteen years. The overall South Nyanza project included establishment of a nucleus sugarcane plantation; development of a network of small farmers, or outgrowers, who would supply additional cane; and a processing compo- nent-a sugar mill initially capable of crushing 60,000 tons of cane a year, 90,000 tons of cane after later expansion. The accounts presented contain all the elements necessary for analysis of much simpler enter- prises but are also complex enough to be useful as a pattern to be adapted by those with specialized knowledge of financial analysis. For an agriculturally based industry included in a project, three basic financial statements should be prepared: balance sheets, income state- ments, and sources-and-uses-of-funds statements. If the project repre- sents an expansion of an existing facility, then these accounts should include historical information for, say, about five years previous to the beginning of the project. Both for enterprises that are to be expanded and new enterprises, these statements would be projected over the life of the project. The balance sheets give a view of the assets and liabilities of the processing enterprise at the end of each accounting period, which is usually a year-a kind of still photograph of the financial state of the enterprise at a given moment. The income statements summarize the revenues and expenses of the enterprise during each accounting period and give a kind of cinematic picture of activities over time. The sources- and-uses-of-funds statements are a summary of the financial transac- tions taking place during each accounting period. In essence, they con- vert the income statement to a cash (or funds) basis. They highlight large transactions, such as the purchase of assets and creation of new obliga- tions (both debt and equity), that appear as changes in the balance sheets for the opening and closing of each period. On the basis of these financial statements, the project analyst can form FINANCIAL ANALYSIS OF PROCESSING INDUSTRIES 191 a judgment about the efficiency of current operations and about how efficient proposed new facilities are likely to be. He can assess the returns to investors if the project is to be financed by private funds or by account- able public enterprises. The statements may reveal losses that will have to be made up through a subsidy if the enterprise is to remain financially solvent; from them the analyst can examine the creditworthiness and liquidity of the enterprise during the project life as a basis for arranging its financing. In general, the project analyst will make use of three sets of ratios, which are derived from the financial statements and which give him insight to help form his financial judgments-efficiency ratios, in- come ratios, and creditworthiness ratios. The financial data essential to analyze any new project are, of course, based on incremental expenses and revenues. The South Nyanza exam- ple for our discussion was a new project, and virtually the whole sugar mill was incremental. (There were a few existing assets.) Many projects, however, will entail expansion of existing facilities. In these instances, the analysis centers on incremental growth in the parent enterprise, the situation with and without the expansion that the parent enterprise will carry out. Costs and revenues that would be realized by the parent enterprise whether or not a particular project is undertaken are not considered in the estimate of the incremental contribution. On the one hand, the potential future effects of a proposed project must be isolated from the overall accounts of the parent enterprise. On the other hand, the project analyst will be concerned not only with the financial dimensions of a proposed expansion alone. He must also be satisfied that the parent enterprise is financially able to carry out the expansion, and that may require projecting financial statements for the enterprise as a whole, including the expansion envisioned by the project. Accounts are kept for operating entities rather than for the persons who own, manage, or are otherwise employed by them. The enterprise represents a group of resources subject to common control. In financial analysis, it is the operating entity that is viewed as controlling the resources and receiving the income. The entity is, in turn, owned by its proprietors or shareholders. The management of the enterprise acts on behalf of the owners, whether private or government. Accounts for operating enterprises are kept on an accrual basis. That is, revenues are recorded in financial statements for the period in which they are earned, and expenses are recorded in the period incurred, re- gardless of when the corresponding cash transactions took place. In contrast, cash accounting shows transactions only when cash payments are actually made. Governments generally keep their accounts on a cash basis, as do some small businesses. Public sector enterprises, however, normally follow the accrual principle because it is more useful for man- agerial decisionmaking. The most common and generalized categories of items included in the accounts of the South Nyanza project appear in italic type in the text of this chapter. If the analyst takes the italicized items and the illustrative 192 FINANCIAL ASPECTS OF PROJECT ANALYSIS tables as a general pattern and adapts them to the particular project he is working on, he will arrive at a satisfactory account for most simple processing enterprises. Conceptual errors would probably be limited and have little effect on the overall project investment decision, although the analyst may wish to verify his projected financial statements by consult- ing an accountant. Consultation with a financial analyst early in project preparation will probably be necessary when the financial statements for the processing plant become more complex. Balance Sheet The most well-known financial statement is the balance sheet. It is a snapshot of an enterprise at a particular point of time. In the South Nyanza example in table 5-1, the assets of the sugar mill are listed above and its liabilities and equity below. Assets and liabilities are listed accord- ing to the U.S. convention of showing the most liquid, or current, first and then progressing through less and less liquid forms to end with fixed assets and long-term liabilities. British usage shows the least liquid first, Table 5-1. Balance Sheets, Factory Capacity of 90,000 Tons, South Nyanza Sugar Company, South Nyanza Sugar Project, Kenya (thousands of KSh, constant 1977 prices) Project year Item 1 9 10 11 Assets Current assets Cash and bank balance 3,323 17,241 69,559 106,234 Accounts receivable-outgrowersa 2,952 47,202 48,047 48,471 Inventories Nucleus estate standing cropb 3,428 25,546 24,181 22,174 Other inventoriesc 1,525 7,000 7,000 7,000 Total current assets 11,228 96,989 148,787 183,879 Fixed assets Buildings and equipment at cost 34,549 469,736 472,094 479,923 Less accumulated depreciation ( 2,872) (207,498) (241,560) (275,741) Construction in progress 84,437 - - - Net fixed assets 116,114 262,238 230,534 204,182 Other assets - - - - Total assets 127,342 359,227 379,321 388,061 Liabdities and equity Liabilities-current Accounts payable - - - Short-term loans - - - - Long-term loans-current portion World Bank - 6,563 6,563 6,563 European Investment Bank - 10,956 10,956 10,956 East African Development Bank - 2,846 2,846 2,844 FINANCIAL ANALYSIS OF PROCESSING INDUSTRIES 193 Table 5-1 (continued) Project year Item 1 9 10 11 Suppliers' credits-current portion Suppliers' credit-Germany - 7,050 7,050 - Suppliers' credit-India - 6,381 6,331 - Taxes payable - - - - Total current liabilities - 33,796 33,746 20,363 Liabilities-long-term Long-term loans World Bank - 98,435 91,872 85,309 European Investment Bank 33,400 54,780 43,824 32,868 U.S. Export-Import (Exim) Bank 7,900 - - - East African Development Bank 6,070 5,690 2,844 - Suppliers' credits Suppliers' credit-Germany 17,200 7,050 - - Suppliers' credit-India 15,500 6,331 - - Total long-term liabilities 80,070 172,286 138,540 118,177 Total liabilities 80,070 206,082 172,286 138,540 Equity Share capital 57,000 196,500 196,500 196,500 Retained earnings ( 9,728) ( 43,355) 10,535 53,021 Total equity 47,272 153,145 207,035 249,521 Total liabilities and equity 127,342 359,227 379,321 388,061 KSh Kenyan shillings. Note: Parentheses indicate negative numbers. Source: Adapted from World Bank, "Kenya: Appraisal of the South Nyanza Sugar Project," 1418-KE (Washington, D.C., 1977; restricted circulation), annex 20, table 12. a. Represents the net value of services and inputs provided to outgrowers (small farm- ers), including company overhead cost allocated to outgrowers. b. Includes investment in sugarcane (current value less production cost of sugarcane; excludes value of land). c. Includes spare parts, tools, and operating materials. working through to the most current. (Also, if assets and liabilities are listed in parallel columns instead of at the top and bottom of a page, U.S. custom is to show assets on the left-hand side, whereas British usage is to put the liabilities on the left.) Assets and liabilities plus equity are defined so that they must always be equal. Thus we have the identity: assets = liabilities + owners' equity. Assets must be owned by the enterprise and be of measurable value. There are three principal kinds of assets: current, fixed, and other. Current assets consist of cash, including checking accounts in a bank; accounts receivable, which are amounts owed to the firm by customers and are expected to be converted into cash in the reasonably near future, usually in less than a year; and inventories intended for rather prompt sale. In the South Nyanza example, the standing crop of sugarcane on the nucleus plantation is treated as an inventory. Fixed assets include durable goods of relatively long life to be used by the enterprise in production of goods and services rather than to be held for sale. Property, plant and equipment, and land are the most common fixed assets. Often, as in the South Nyanza example, buildings 194 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 5-2. Income Statements, Factory Capacity of 90,000 Tons, South Nyanza Sugar Company (thousands of KSh, constant 1977 prices) Project year Item 1 9 10 11 Revenue Sale of sugar" - 227,378 244,351 265,487 Sale of molassesb - 9,194 9,880 10,734 Total revenue - 236,572 254,231 276,221 Cash operating expenses Nucleus estate sugarcane production' - 11,173 9,657 10,241 Outgrowers' sugarcane purchased - 72,296 80,532 85,404 Molasses-transport and excise tax' - 5,412 5,815 6,318 Factory variable cost - 15,133 16,263 17,670 Factory overhead - 10,714 10,714 10,714 Total cost of goods sold - 114,728 122,981 130,347 Gross income (profit) - 121,844 131,250 145,847 Selling, general, and administrative expenses General administration 646 7,843 7,843 7,843 Training 37 267 267 267 Research 477 627 627 627 Management fee-nonvariable 1,121 1,210 1,210 1,210 Management fee-variable - 3,890 4,225 4,886 Total selling, general, and administrative expenses 2,281 13,837 14,172 14,833 Funds from operations (operating income before depreciation) (2,281) 108,007 117,078 131,041 Noncash operating expenses Depreciation Factory, general administration, research and housing assets 748 24,172 24,172 24,172 Nucleus estate and outgrowers' assets 2,124 15,628 18,160 20,125 Other - - - - Total noncash operating expenses 2,872 39,800 42,332 44,297 Total operating expenses 5,153 168,365 179,485 189,477 Operating income (profit) (5,153) 68,207 74,746 86,744 Nonoperating income and expenses Interest received ( - ) ( 4,245) ( 4,770) ( 5,048) Interest paid 4,575 19,738 17,008 14,545 Duties and indirect taxes - - - Subsidies - ) ( - ) ( ) - ) Total nonoperating expenses 4,575 15,493 12,238 9,497 Income (profit) before income taxes (9,728) 52,714 62,508 77,247 Income taxes - 8,618 34,761 Net income (profit) after taxes (9,728) 52,714 53,890 42,486 Source. Same as table 5-1 (annex 20, table 11). a. Valued at KSh3,050 per ton b. Valued at KSh350 per ton f.o.b. Mombasa. c. Represents total cost of production of sugarcane on the nucleus estate. d. Value of sugarcane purchased from outgrowers at KSh 155 per ton. e. Includes excise tax of KSh6 per ton and transport charges of KShlO per ton from factory to dockside in Mombasa. FINANCIAL ANALYSIS OF PROCESSING INDUSTRIES 195 and equipment at cost are shown at their original cost, and then the accumulated depreciation allowances are deducted. Land, by convention, is never depreciated. In the South Nyanza example, construction in progress is shown separately as a fixed asset. A third kind of asset, called simply other assets, is not needed in the South Nyanza balance sheet. This category would include investments in other companies or long-term securities; deferred expenses, such as start-up expenses for a new project, to be charged over several accounting periods; intangible assets such as patents and trademarks that have no physical existence but are of value to the enterprise; and miscellaneous additional assets peculiar to par- ticular types of enterprises. Liabilities are the claims against the assets of the enterprise that creditors hold-in other words, the outstanding debts of the enterprise. There are two principal kinds. Current liabilities comprise debts falling due within a year, such as accounts payable, short-term loans, and the current portion of long-term loans and suppliers' credits that must be paid within the coming accounting period. Taxes payable but not yet paid are also a current liability. Long-term liabilities are the debts that become payable after one year from the date of the balance sheet. They may consist of medium- and long-term loans and suppliers' credits. Owners' equity consists of claims against the assets of the enterprise by its owners-in other words, what is left after all liabilities have been deducted from total assets. In the case of public sector enterprises, the owner is generally the government, although some public sector firms may have nongovernment shareholders. Owner's equity generally takes the form of share capital paid in by owners of the enterprise and retained earnings ("reserves" in British usage). Various other kinds of reserves may also appear under equity that do not fit precisely into the descrip- tion of capital and retained earnings. Income Statement The income statement is a financial report that summarizes the rev- enues and expenses of an enterprise during the accounting period. It is thus a statement that shows the results of the operation of the enterprise during the period. Net income, or profit, is what is left after expenses incurred in production of the goods and services delivered have been deducted from the revenues earned on the sale of these goods and ser- vices. In other words, income (profit) = revenues - expenses. Thus, in the South Nyanza example in table 5-2, the net income is the sales revenue less all expenses. Revenue in most processing enterprises will come from sales of goods and services-in the South Nyanza example, sugar and molasses. Sales are shown net of sales discounts, returned goods, and sales taxes. The cash operating expenses list all the cash expenditures incurred to 196 FINANCIAL ASPECTS OF PROJECT ANALYSIS produce the output. Important among these are expenditures for labor (which in the South Nyanza example is included in factory variable cost) and for raw materials, in this case largely sugarcane purchased from outgrowers. Subtracting these direct costs incurred in the production of the goods sold from the revenue gives the gross income (or gross profit). Selling, general, and administrative expenses are shown next. These include a number of overhead items-in the South Nyanza example, general administration, training, research, and the management fee to be paid the firm that will operate the sugar mill. Maintenance costs are often included as a separate entry in this category. We now reach the funds from operations, also called the operating income before depreciation. This is the net benefit or cash flow of the enterprise that arises from operations. If the account is built on an incremental basis, it is the incremental net benefit from operations. (It is not the incremental net benefit or cash flow for the enterprise as a whole during each year over the life of the project, since we must deduct the investment costs that come from the sources-and-uses-of-funds state- ment discussed in the next section. This expense is shown as depreciation in the income statement. See the last section of this chapter, on financial rate of return.) Funds from operations are sometimes also called the internally generated funds. Funds from operations becomes the first ele- ment in the sources-and-uses-of-funds statement and is also the basis for transferring the net benefits of the enterprise to the summary project accounts from which the estimated economic return of the project is derived. Before this is done, however, any element in the revenues, cash operating expenses, and selling, general, and administrative expenses that is a direct transfer payment or that has an economic value different from its market price must be omitted or revalued along the lines given in chapter 7. Next we list the noncash operating expenses, of which the primary element is depreciation. In accounting, depreciation refers to the process of allocating a portion of the original cost of a fixed asset to each account- ing period so that the value is gradually used up, or written off, during the course of the useful life of the asset. Allowance may be made for the resale value of the fixed asset-its residual value-at the end of its useful life to the enterprise. The most common depreciation method is "straight-line depreciation," which allocates an equal portion of the value of the fixed asset to each accounting period; in contrast, various methods of accelerated depreciation allocate more of the depreciation to earlier accounting periods than to later. The principal other noncash operating expense is amortization, the gradual writing off of intangible assets such as royalties or patents. Deducting the noncash operating expenses gives us operating income (or operating profit), also called the profit before interest and taxes. Nonoperating income and expense are subtracted next. When an enter- prise will receive interest payments, as is the case of the South Nyanza example, it is convenient to include interest received at this point, so that all interest transactions will appear at one point in the income state- FINANCIAL ANALYSIS OF PROCESSING INDUSTRIES 197 ment. Interest received is thus shown as a "negative expense." In most enterprises, interest paid is among the most important nonoperating income and expense items. Duties and indirect taxes are also included among the nonoperating income and expenses unless they have been allowed for elsewhere. Duties, for instance, may appropriately be in- cluded among the expenses. In the South Nyanza example, duties on imported machinery were included in the purchase price of the machin- ery and thus were not shown separately under this entry. Indirect taxes also may not appear separately in income statements. In the South Nyanza example, we noted earlier that sales taxes were deducted before entering the sale revenues in accord with normal practice. In effect, the enterprise is simply acting on behalf of the government when it collects a sales tax, and the amount of the tax does not enter the income statement. In the South Nyanza example, the excise tax on molasses also was not shown separately but is properly included as part of the expenses. Among the indirect taxes that might be shown are franchise taxes and a value added tax-a tax levied as a proportion of the increased value generated at each stage in the processing and handling of a product up to the final sale. Finally appear subsidies. Again, subsidies may not appear at this point in the income statement. They may be incorporated elsewhere (for example, in the price that an enterprise pays for a subsidized input), or they may be shown as a revenue (as in the case of export incentive payments). Thus we reach income (profit) before income taxes. Now, deducting the income taxes, we obtain the final entry, the net income (profit) after taxes. This is the return to the owners of the enterprise and is available either for distribution to them or for reinvestment in the enterprise. Financial accounts must be linked to all other accounts. As the accoun- tants put it, accounts must be "articulated." We noted that the funds from operations in the income statement becomes the first element in the sources-and-uses-of-funds statement. The income statement is also a bridge between successive balance sheets. The net income, after payment of dividends to shareholders, is transferred to the balance sheet as re- tained earnings and thereby increases the owners' equity. To trace this transaction, a reconciliation statement, such as a retained earnings statement, would be required to show any distribution of earnings as dividends before the retained earnings are added to the owners' equity in the balance sheet. In the South Nyanza example, it was assumed that all earnings would be retained by the enterprise throughout the sixteen years for which the projected accounts were prepared. Looking at years 9 and 10 reproduced in tables 5-1 and 5-2, we can see the articulation between the balance sheet and the income statement. The net income in year 10 given in the income statement in table 5-2 is KSh53,890 thousand. Adding this amount to the retained earnings at the end of year 9, shown in the projected balance sheets in table 5-1 to be - KSh43,355 thousand, gives a retained earnings in year 10 of KShlO,535 thousand ( - 43,355 + 53,890 = 10,535). Table 5-3 shows projected retained earn- ings statements for the South Nyanza example. Reconciliation accounts 198 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 5-3. Retained Earnings Statements, Factory Capacity of 90,000 Tons, South Nyanza Sugar Company (thousands of KSh, constant 1977 prices) Project year Item 1 9 10 11 Net income (9,728) 52,714 53,890 42,486 Dividends - - - - Increase in retained earnings (9,728) 52,714 53,890 42,486 Accumulated retained earnings (9,728) (43,355) 10,535 53,021 Source: Same as table 5-2. are uncommon for government-owned operating entities that retain all earnings in the enterprise. Sources-and-Uses-of-Funds Statement The sources-and-uses-of-funds statement highlights the movements of investment funds over the life of the project. It is a vehicle for measuring the total flow of financial resources into and out of an enterprise during an accounting period and for projecting this total flow into the future. The sources-and-uses-of-funds statement is also called the sources-and- applications-of-funds statement, the funds statement, the statement of change in working capital, or sometimes simply the cash flow, since the flow of funds is reflected in the final analysis by changes in the cash position of an enterprise. This accounting definition of cash flow, how- ever, differs from that used in project analysis to measure the return on the resources engaged in the project. The most common sources of funds are outlined in the first part of table 5-4. The first of these is funds from operations (or the operating income before depreciation). When the accounts are laid out following the pattern given here, this can be taken directly from the income statement as illustrated in the South Nyanza example. Often, however, the funds from operations does not show as a separate item in a set of accounts and will have to be constructed by adding depreciation and other noncash charges back to the operating income. To the funds from operations are added the increase in equity, the long-term loans received, and the increase (decrease) in short-term loans. In the South Nyanza example, equity and loans come from a wide variety of sources. The government of Kenya contributes part of the equity financ- ing that, in turn, it is to obtain from the proceeds of a World Bank loan, and part of the equity comes from a private firm. Long-term loans come from a variety of international financing institutions and from suppliers' credits. The capital structure of the firm is such that it does not need short-term loans in the years we have chosen as illustrative examples, FINANCIAL ANALYSIS OF PROCESSING INDUSIRIES 199 but in many agricultural processing enterprises short-term loans would be needed to enable the enterprise to carry inventories of raw materials purchased at harvest time and stocks of processed goods that will be sold during the year. Interest received is the next source of funds; in the South Nyanza example, it comes from short-term loans made to outgrowers. The in- crease (decrease) in accounts payable and other short-term liabilities (except current portion of long-term loans received) follows. An enterprise might obtain part of its funds by increasing the amounts purchased on terms from its suppliers or by postponing payment to its suppliers. If it reduces the amount purchased on terms or the average time it takes to pay its suppliers from one year to the next, this would cause a decrease in accounts payable and a reduction of the funds available. Because we are looking, in general, at an expanding firm that will be increasing its accounts payable in the normal course of widening the scope of opera- tions under the project, an increase in accounts payable will usually be found in the sources-and-uses-of-funds statement. When a decrease occurs, however, it is convenient to enter it as a "negative source" in the accounts rather than as an additional line among the uses of funds. In some agricultural projects, the processing enterprise may be expected to operate at a loss to increase the income of farmers. If so, the firm may expect direct subsidies to be one source of its funds. Among the major uses of funds (second part of table 5-4) in the pro- jected sources-and-uses-of-funds statements for a project with an ex- panding processing enterprise will likely be the increase (decrease) in gross fixed assets. This item shows the investment in fixed assets during each year; in the South Nyanza example, this is principally investment in new milling capacity. In other cases an enterprise may decrease fixed assets by selling them. If this transaction exceeds the purchase of fixed assets, the net result would most easily be shown as a "negative use" among the uses of funds rather than as a separate entry for the proceeds from the sales of fixed assets among the sources of funds. A major item in the projected sources-and-uses-of-funds statements for an enterprise included in an agricultural project will most likely be repayment of long-term loans. (Recall that among the sources of funds shown is the increase or decrease in short-term loans. Since this is shown on a net basis, there is no need for a separate entry among the uses of funds for repayment of short-term loans.) Only the principal repayment is included under the repayment of long-term loans. Interest payments on long-term loans and interest payments on short-term loans are segregated and shown separately. (In the South Nyanza example, the analyst assumed that the repayment of the short-term loans, shown as a decrease in short-term loans among the sources of funds, would be made at the very beginning of the accounting period; hence, there is no short-term interest shown in the account for year 9.) An enterprise that has borrowed for expansion, such as the South Nyanza Sugar Company, may have to pay loan commitment fees for undisbursed amounts of loans that have been made to it. 200 FINANCIAL ASPECTS OF PROJECT ANALYSIS The increase (decrease) in inventories shows the change in the inventory position of the enterprise. Because most projected accounts are for expanding enterprises, it is likely that this entry will reflect an increase in inventories; the entry is therefore included among the uses of funds. Sometimes, however, there may be a decrease in inventories. Rather than have an additional line under sources of funds, it is convenient to treat a reduction in inventory as a negative use. In the South Nyanza example, the major inventory is the standing cane crop on the nucleus Table 5-4. Sources-and-Uses-of-Funds Statements, Factory Capacity of 90,000 Tons, South Nyanza Sugar Company (thousands of KSh, constant 1977 prices) Project year Item 1 9 10 11 Sources Funds from operations (operating income before depreciation) ( 2,281) 108,007 117,078 131,041 Increase in equity Government 54,150 - - - Mehta Group 2,850 - - - Total increase in equity 57,000 - - - Long-term loans received World Bank - - - - Suppliers' credit 32,700 - - - European Investment Bank 33,400 - - - Exim Bank 7,900 - - - East African Development Bank 6,070 - - - Total long-term loans received 80,070 - - - Increase (decrease) in short-term loans - ( 19,000) - - Total increase (decrease) in short-term loans - ( 19,000) - - Interest received - 4,245 4,770 5,048 Increase (decrease) in accounts payable and other short-term liabilities (except current portion of long-term loans received) - - Subsidies - - - Total sources 134,789 93,252 121,848 136,089 Uses Increase (decrease) in gross fixed assets' 118,986 22,445 10,628 18,064 Repayment of long-term loans World Bank - 6,563 6,563 6,563 Suppliers' credit - 13,431 13,431 13,381 European Investment Bank - 10,956 10,956 10,956 Exim Bank - - - - East African Development Bank - 2,846 2,846 2,846 Total repayment of long-term loans - 33,796 33,796 33,746 FINANCIAL ANALYSIS OF PROCESSING INDUSTRIES 201 Table 5-4 (continued) Project year Item 1 9 10 11 Interest payments on long-term loans World Bank - 11,370 10,681 9,992 Suppliers' credit - 3,482 2,411 1,607 European Investment Bank 2,004 3,946 3,289 2,632 Exim Bank 711 - - - East African Development Bank 668 940 627 314 Interest payments on short-term loans - - - - Total interest payments 3,383 19,738 17,008 14,545 Loan commitment fees World Bank 984 - - - Exim Bank 69 - - - East African Development Bank 139 - - - Total loan commitment fees 1,192 - - - Total debt service 4,575 53,534 50,804 48,291 Increase (decrease) in inventories Standing cane crop 3,428 ( 827) ( 1,365) ( 2,007) Other inventoriesb 1,525 - - - Total change in inventories 4,953 ( 827) ( 1,365) ( 2,007) Increase (decrease) in accounts receivable 2,952 2,295 845 424 Increase (decrease) in other short- term assets except cash - - - - Income taxes paid - - 8,618 34,761 Dividends paid - - - - Adjustments for items not covered above - - - - Total uses 131,466 77,447 69,530 99,533 Net funds flow Current surplus (deficit) 3,323 15,805 52,318 36,556 Opening cash balance - 1,436 17,241 69,559 Cumulative surplus (deficit) 3,323 17,241 69,559 106,115 Source: Same as table 5-1 (annex 20, table 13). a. Includes investment in the factory, agriculture, administration, housing, and com- pany-related research. b. Includes spare parts, tools, and operating materials. plantation. As indicated in table 5-4, this inventory does decrease during years 9 through 11-thus it is shown as a negative entry in the account. The increase (decrease) in accounts receivable appears next. If a firm is expanding, it will likely be extending credit to an increasing number of customers, and its accounts receivable will expand. But if it is able to reduce the average length between delivery and payment or be more restrictive in extending credit, its accounts receivable may decrease during the year and be shown as a negative use. The increase (decrease) in other short-term assets except cash would allow for changes in holdings of such short-term assets as notes, certificates of deposit, or treasury bills. Income taxes paid are an obvious use of funds for an enterprise, and there may be dividends paid by the enterprise to its equity owners. 202 FINANCIAL ASPECTS OF PROJECT ANALYSIS Finally, an entry for adjustments for items not covered above comprises those items that for various reasons do not fit well into one of the pattern categories. Any items of substance in this entry should be fully disclosed in footnotes to the accounts. What remains is the net funds flow, of which the first element is the current surplus (deficit). Adding the opening cash balance to the surplus or deficit gives the cumulative surplus (deficit). If the projected accounts indicate a cumulative cash deficit-a deficiency of funds-then some arrangements will have to be made to sustain the enterprise during this period. It may be necessary to reduce planned dividends, arrange for additional loans or equity, or in some other way plan to provide the necessary funds. Projecting the sources-and-uses-of-funds statements enables the analyst to be certain that the available financing for the enterprise will be sufficient to cover the investment program-including increases in in- ventories, other permanent working capital, and all cash expenditures for operations-and to cover obligations of interest and the principal repayment on all outstanding loans. Projecting the sources-and-uses-of- funds statements year by year makes it possible to check the timing of inflows from various sources to be certain that these inflows will be available as the need arises. Credit agencies can assess the total flow of funds from operations before debt service to determine how adequately the debt service is covered. Owners will be looking at the projected flow of funds after debt service to judge what their returns will be. For private investors, the funds generated after debt service and the projected div- idends will be important elements in their decisions about whether to participate in the project. Financial Ratios From the projected financial statements for an enterprise, the financial analyst is able to calculate financial ratios that allow him to form a judgment about the efficiency of the enterprise, its return on key aggre- gates, and its creditworthiness. We will discuss several of the most significant of these ratios, but there are many others that financial analysts use and that are particularly appropriate for specific kinds of enterprises. For each ratio we will discuss, the means of computation is summarized in table 5-5. Two examples of the application of the ratios are given in the table, based on years 10 and 11 of the South Nyanza Sugar Company accounts reproduced in tables 5-1, 5-2, and 5-4. In general, it is not possible to give ranges within which financial ratios should fall. Instead, the analyst will have to form a judgment about whether the ratio indicates an acceptable situation for the kind of enter- prise that is the subject of the projected accounts. For more information about the use of financial ratios, the project analyst may consult a FINANCIAL ANALYSIS OF PROCESSING INDUSTRIES 203 standard accounting text or Upper (1979), from which this discussion draws heavily. The ratios given here have all been computed using the figures at the end of each year. This weights the analysis toward the last months of operations; as long as clarity and consistency are maintained, this usu- ally poses no problem. If the activities of an enterprise are highly season- al, as is often the case in agricultural projects, calculating the ratios on a year-end basis could easily be misleading. In that instance, the analyst may want to examine the pattern of seasonal fluctuations within the accounting period and make a judgment about whether the seasonal variation would affect his conclusions about the efficiency, return, or creditworthiness of the proposed enterprise. Efficiency ratios The first group of ratios (first part of table 5-5) enables the analyst to form a judgment about the efficiency of the proposed enterprise. They provide measurements of asset use and expense control. Inventory turnover measures the number of times that an enterprise turns over its stock each year and indicates the amount of inventory required to support a given level of sales. The ratio can be computed in several ways. In the form given here, the cost of goods sold is divided by the inventory. In the South Nyanza example in table 5-5, for year 10 this amounts to 3.94 times a year. In agricultural processing industries, this ratio may be low compared with that of many manufacturing enter- prises; this lower ratio reflects the highly seasonal nature of agricultural processing. The inventory turnover can also relate to the average length of time a firm keeps its inventory on hand. In the South Nyanza example, the firm has about ninety-three days of inventory on hand at the end of year 10. We determine this by dividing the days in the year by the inventory turnover ratio (365 + 3.94 = 93). We could also state this in months-the firm has about three months of inventory on hand-by dividing the months of the year by the inventory turnover ratio (12 + 3.94 = 3). A low turnover ratio may mean that a company with large stocks on hand may find it difficult to sell its product, and this may be an indicator that the management is not able to control its inventory effec- tively. A low turnover ratio may, however, also mean that large stocks must be held to ensure that production schedules are met. A low ratio means a sizeable amount of funds are tied up. A high turnover ratio may mean that the enterprise is able to recover its inventory investment rapidly and that there is a good demand for its products. On the one hand, when the ratio is much higher than the industry average, it may mean that the enterprise is very efficient in managing its inventories. On the other hand, it may mean that the enterprise is starved of funds and cannot afford to maintain a sufficient inventory; as a result, it may be forced to forgo sales opportunities. The operating ratio is obtained by dividing the operating expenses by Table 5-5. Financial Ratios, Factory Capacity of 90,000 Tons, South Nyanza Sugar Company Project year Ratio 10 11 Efficiency ratios Inventory turnover = Cost of goods sold 122,981 =3.94 130,347 =4.47 Inventory 24,181 + 7,000 22,174 + 7,000 Operating ratio (percent) = Operating expenses 179,485 x 100 = 71 189,477 x 100 = 69 Revenue 254,231 276,221 Income ratios Return on sales (percent) = Net income 53,890 x 100 = 21 42,486 x 100 = 15 Revenue 254,231 276,221 Return on equity (percent) = Net income 53,890 x 100 = 26 42,486 x 100 = 17 Equity 207,035 249,521 Return on assets (percent) = Operatmg income 74,746 x 100 = 20 86,744 x 100 = 22 Assets 379,321 388,061 Creditworthiness ratios Current ratio = Current assets 148,787 183,879 = 4.41 - 9.03 Current liabilities 33,746 20,363 Debt-equity ratio = Long-term liabilities 138,540 = 0.40 118,177 = 0.32 Long-term liabilities + equity 138,540 + 207,035 118,177 + 249,521 and Equity 207,035 = 0.60 249,521 = 0.68 Long-term liabilities + equity 138,540 + 207,035 118,177 + 249,521 therefore Debt-equity ratio = 40:60 32:68 Debt service coverage ratio = Net income + depreciation 53,890 + 24,172 42,486 + 24,172 + interest paid + 18,160 + 17,008 = + 20,125 + 14,545 = 2.10 Interest paid 17,008 + 33,796 14,545 + 33,746 + repayment of long-term loans Source: Tables 5-1, 5-2, and 5-4. 206 FINANCIAL ASPECTS OF PROJECT ANALYSIS the revenue. In the South Nyanza example, for year 10 the operating ratio is 71 percent. The operating ratio is an indicator of the ability of the management to control operating costs, including administrative ex- penses. This ratio is most useful when operations of the same enterprise are compared year by year or when the enterprise is compared with similar industries. If the ratio is increasing, it may mean that the cost of raw materials is increasing, that the management is having problems controlling labor costs, that there is waste in the production process, or, when sales decline, that expenses have not been trimmed proportion- ately. It may also mean that there is substantial competition and that it is necessary to reduce prices. If there is uncertainty about whether the increase in the ratio is due to increasing costs or decreasing sales prices, the answer can usually be found by taking the operating expenses and dividing that by the company sales volume on a unit basis (for instance, the number of tons of refined sugar sold in the South Nyanza example). In general, the larger the capital investment is relative to sales volume, the lower will be the operating ratio. If a company has made a large invest- ment, it must be able to recover it with a high cash flow, which can only be accomplished generally through a low operating ratio. If an enterprise has a high operating ratio, say in the neighborhood of 90 percent, it may have difficulty making an adequate return. If it is abnormally low, say 50 percent, then some costs have likely been omitted or underestimated. Income ratios The long-term financial viability of an enterprise depends on the funds it can generate for reinvestment and growth and on its ability to provide a satisfactory return on investment. We will look at three ratios (second part of table 5-5) that can be used to judge net income or profitability- return on sales, return on equity, and return on assets. Because of their importance in project analysis and because they are somewhat more difficult to calculate, we will defer to the next section consideration of three other income measures-the rate of return on all resources en- gaged, the rate of return on equity before income taxes, and the rate of return on equity after taxes. Income ratios are calculated on a year-to-year basis and may be noted in the projected statements for an enterprise. That will provide some idea of the changing income ratios over the life of the project. If a company is granted a tax holiday for the first years of its operations, it is necessary to forecast its accounts through the end of the tax holiday period to deter- mine the full effect of taxes on the company. The return on sales shows how large an operating margin the enter- prise has on its sales. This is determined by dividing the net income by the revenue. In the South Nyanza example, the return on sales in year 10 is 21 percent. The lower the return on sales-hence, the operating mar- gin-the greater the sales that must be made to make an adequate return FINANCIAL ANALYSIS OF PROCESSING INDUSTRIES 207 on investment. The ratio is most useful when comparing companies in the same sector or industry or when analyzing the results of past opera- tions and comparing projections for future expansions. Comparisons among industries may have little meaning because of the widely varying structure of different industries. One of the most important ratios is the return on equity. It is obtained by dividing the net income after taxes by the equity. In the South Nyanza example, for year 10 this is 26 percent. This ratio is frequently used because it is one of the main criteria by which owners are guided in their investment decisions. It can also be used to weigh incentives for indi- vidual owners if the enterprise is to be in the private sector. The earning power of the assets of an enterprise is vital to its success. A principal means of judging this is to determine the return on assets, which is the operating income divided by the assets. In the South Nyanza example for year 10, this is 20 percent. The return on assets is the financial ratio that comes closest to the rate of return on all resources engaged (for more detail, see the next section). A crude rule of thumb is that, once the enterprise is operating at normal capacity, the return on assets should exceed the cost of capital in the society as measured by, say, the bank lending rate to industries-provided that there is no interest subsidy. Public sector enterprises usually should also be able to realize a return of this order, since if they do not, it is evidence that public funds would be better employed in other enterprises. Creditworthiness ratios The purpose of creditworthiness ratios (final part of table 5-5) is to enable a judgment about the degree of financial risk inherent in the enterprise before undertaking a project. They are also a basis for the project analyst to estimate what financing an enterprise will need and what will be suitable terms. Some firms, especially those in the private sector, attempt to finance their projects with as much debt as possible so they may realize maximum return on their own equity contribution. This can be risky, especially in an unstable industry or in an economy subject to substantial business cycles. An enterprise should be financed in such a way that it is able to survive adverse circumstances without emergency measures. The current ratio is the current assets divided by the current liabilities. In the South Nyanza example, for year 10 the ratio is 4.41. From the standpoint of the credit agency, the current ratio is an indication of the margin that the enterprise has for its current assets to shrink in value before it faces difficulty in meeting its current obligations. In the South Nyanza example, in year 10-even if the current assets are worth only one-fourth the value given in the accounts-the sugar mill could still pay its creditors from these assets. A rule of thumb sometimes applied to the current ratio is that it should 208 FINANCIAL ASPECTS OF PROJECT ANALYSIS be around 2. As with all rules of thumb, this figure should be used with caution. If the company has a rapid inventory turnover and can easily collect its receivables, the current ratio can be lower. If the ratio drops to near 1, then the enterprise will be in a potentially unstable position. If the ratio is low, it may mean that the enterprise is undercapitalized, and consideration will have to be given to providing more capital, either through increased equity or more long-term debt. Faced with a low current ratio, an enterprise will have to exist on a day-to-day basis, and thus it may have to adopt uneconomic practices. Its products may have to be sold at lower prices to receive payment in cash, or it may lose sales to competitors that can offer better credit terms. It may not be able to carry sufficient inventories to meet its sales needs. Inventories of raw material may be so low that its production efficiency is impaired. It may have to buy from importers in high-cost, small lots instead of buying large, low-priced shipments of inputs direct from overseas suppliers, and it may be forced to buy on credit instead of being able to take advantage of cash discounts. With a low current ratio, an enterprise may be forced to defer preventive maintenance, and this drives up costs later. An important financial ratio for credit agencies is the debt-equity ratio. The amount of equity in an enterprise can be described as a "cushion" by which a company can absorb initial losses or weather bad times. Because debt carries a fixed rate of interest and fixed repayment of principal, too much debt may saddle a company with obligations it cannot meet when conditions are unfavorable. (A better measure of the cushion is the debt service coverage ratio, discussed below.) The debt-equity ratio is calculated by dividing long-term liabilities by the sum of long-term liabilities plus equity to obtain the proportion that long-term liabilities are to total debt and equity, and then by dividing equity by the sum of the long-term liabilities plus equity to obtain the proportion that equity is of the total debt and equity. These are then compared in the form of a ratio. In the case of the South Nyanza example, for year 10 the long-term liabilities divided by the sum of the long-term liabilities plus the equity is 0.40. The equity divided by the sum of the long-term liabilities plus equity is 0.60. The debt-equity ratio, therefore, is 40 to 60. This may be interpreted as saying that, of the total capitaliza- tion in the enterprise, 40 percent is debt and 60 percent is equity. There is no good rule of thumb for the debt-equity ratio. In newly established enterprises, equity ideally should exceed the debt, but in many develop- ing countries equity capital may be scarce, and such a conservative rule may not be sensible given the national objectives. If the enterprise is in the public sector, with a high proportion of the debt held by public sector agencies, the debt-cquity ratio may lose some of its importance because of the presumption that, if the company falls on hard times, it will be possible to renegotiate some portion of the debt held by public agencies. In agricultural projects, enterprises are likely to need a strong equity base because they process or sell commodities that may sharply fluctuate in price and that are subject to adverse weather conditions or a fall in crop or livestock production. FINANCIAL ANALYSIS OF PROCESSING INDUSTRIES 209 The most comprehensive ratio of creditworthiness is the debt service coverage ratio. This is the net income plus depreciation plus interest paid divided by interest paid plus repayment of long-term loans. In the case of the South Nyanza example, for year 10 the debt service coverage ratio is 2.23. The debt service coverage ratio could also be calculated on a before-tax basis, in which case it is simply the funds from operations divided by the interest plus repayment of long-term loans. In the case of the South Nyanza example, for year 10 (not shown in table 5-5) this would be 2.30 [117,078 (17,008 + 33,796) = 2.303. Financial analysts who use the af- ter-tax basis argue that taxation is a routine and unavoidable aspect of doing business. But analysts who prefer the before-tax basis argue that debt service coverage should be seen as the ability of funds from opera- tions to satisfy debt obligations before such tax shields as depreciation and other noncash charges are applied to reduce taxable profits. The viewpoint of the analyst will be affected by whether the company is in the public or private sector. Again, it is hard to give a rule of thumb for the debt service coverage ratio. One way of looking at it is that, in the case of the South Nyanza Sugar Company in year 10, the net income plus depreciation plus interest paid could drop by half and the enterprise could still meet its debt obligations. The analyst would have to look at each of the elements making up the ratio and form a judgment about how likely it is that any element could vary from the projected amount. A declining trend in the debt service coverage ratio in a projected account might indicate overly ambitious expansion. A persistently low debt service coverage ratio might indicate that consideration should be given to changing the credit terms to lengthen the repayment period. The debt service coverage ratio interpreted alone can be misleading. There are many requirements that a successful enterprise must satisfy in addition to simply covering its debt service obligations. A full analysis of the sources and uses of funds for the enterprise is needed. The true buffer for debt service is only the pool of funds remaining after meeting all requirements for maintenance and improvement of current operations and orderly expansion. Financial Rate of Return A useful financial measure that is very important in project analysis is the financial rate of return. We will discuss three variations that differ only in the standpoint from which the calculations are made-the finan- cial rate of return to all resources engaged, the financial rate of return to equity, and the financial rate of return to equity after taxes. Calculations of rates of return are based on an incremental net benefit flow. This is the "cash flow" that is meant by references to discounted cash flow measures of project worth such as the net present worth, the internal rate of return, or the net benefit-investment ratio (all are dis- 210 FINANCIAL ASPECTS OF PROJECT ANALYSIS cussed in detail in chapters 9 and 10). In this section we will discuss only derivation of the incremental net benefit; the discussion of discounting and of the measures based on incremental net benefit flows will be found in chapter 9. In rate of return calculations we want to determine the actual cash inflows and outflows of the project each year and incorporate them in the incremental net benefit. Noncash receipts and expenditures are omitted (except for items in kind such as those we discussed in chapter 4 in connection with the farm budgets). Thus, the year an investment is made it reduces the net benefit for that year; when a revenue is realized, it too is reflected in the same year it is received. Because we are preparing the projected accounts over the life of the project, it is unnecessary to include depreciation (which is the major noncash expenditure in most accounts) to allow on an annual basis for the capital value consumed during the year. From the projected income statements and sources-and-uses-of-funds statements for an enterprise as we have laid them out, we can determine the incremental net benefit streams we need to calculate the financial rate of return. The general format is given in table 5-6 and is illustrated by the South Nyanza Sugar Project accounts examined in tables 5-2 and 5-4. All the relevant entries are included in table 5-6 for illustrative purposes, even if the South Nyanza example did not use a particular entry. The entries appear in the order they are found when consulting Table 5-6. Derivation of Incremental Net Benefit, Factory Capacity of 90,000 Tons, South Nyanza Sugar Company (thousands of KSh, constant 1977 prices) Project year Without Item project 1 9 10 11 Inflow Revenue - - 236,572 254,231 276,221 Subsidies - - - -- Total inflow - - 236,572 254,231 276,221 Outflow Cash operating expenses - - 114,728 122,981 130,347 Selling, general, and administrative expenses - 2,281 13,837 14,172 14,833 [Funds from operations] - [( 2,281) 108,007 117,078 131,041] Duties and indirect taxes - - - - - Increase (decrease) in gross fixed assets - 118,986 22,445 10,628 18,064 Increase (decrease) in inventories - 4,953 ( 827) ( 1,365) ( 2,007) Total outflow - 126,220 150,183 146,416 161,237 Net benefit before financing Total - (126,220) 86,389 107,815 114,984 Incremental - (126,220) 86,389 107,815 114,984 210 FINANCIAL ASPECTS OF PROJECT ANALYSIS cussed in detail in chapters 9 and 10). In this section we will discuss only derivation of the incremental net benefit; the discussion of discounting and of the measures based on incremental net benefit flows will be found in chapter 9. In rate of return calculations we want to determine the actual cash inflows and outflows of the project each year and incorporate them in the incremental net benefit. Noncash receipts and expenditures are omitted (except for items in kind such as those we discussed in chapter 4 in connection with the farm budgets). Thus, the year an investment is made it reduces the net benefit for that year; when a revenue is realized, it too is reflected in the same year it is received. Because we are preparing the projected accounts over the life of the project, it is unnecessary to include depreciation (which is the major noncash expenditure in most accounts) to allow on an annual basis for the capital value consumed during the year. From the projected income statements and sources-and-uses-of-funds statements for an enterprise as we have laid them out, we can determine the incremental net benefit streams we need to calculate the financial rate of return. The general format is given in table 5-6 and is illustrated by the South Nyanza Sugar Project accounts examined in tables 5-2 and 5-4. All the relevant entries are included in table 5-6 for illustrative purposes, even if the South Nyanza example did not use a particular entry. The entries appear in the order they are found when consulting Table 5-6. Derivation of Incremental Net Benefit, Factory Capacity of 90,000 Tons, South Nyanza Sugar Company (thousands of KSh, constant 1977 prices) Project year Without Item project 1 9 10 11 Inflow Revenue - - 236,572 254,231 276,221 Subsidies - - - -- Total inflow - - 236,572 254,231 276,221 Outflow Cash operating expenses - - 114,728 122,981 130,347 Selling, general, and administrative expenses - 2,281 13,837 14,172 14,833 [Funds from operations] - [( 2,281) 108,007 117,078 131,041] Duties and indirect taxes - - - - - Increase (decrease) in gross fixed assets - 118,986 22,445 10,628 18,064 Increase (decrease) in inventories - 4,953 ( 827) ( 1,365) ( 2,007) Total outflow - 126,220 150,183 146,416 161,237 Net benefit before financing Total - (126,220) 86,389 107,815 114,984 Incremental - (126,220) 86,389 107,815 114,984 FINANCIAL ANALYSIS OF PROCESSING INDUSTRIES 211 Table 5-6 (continued) Project year Without Item project 1 9 10 11 Financing Long-term loans received - 80,070 - - - Increase (decrease) in short- term loans - - ( 19,000) - - Interest received - - 4,245 4,770 5,048 Increase (decrease) in accounts payable and other short-term liabilities - - - - - Repayment of long-term loans - - ( 33,796) ( 33,796) ( 33,746) Interest payments - ( 3,383) ( 19,738) ( 17,008) ( 14,545) Loan commitment fees - ( 1,192) - - - Decrease (increase) in accounts receivable - ( 2,952) ( 2,295) ( 845) ( 424) Decrease (increase) in other short-term assets except cash - - - - - Net financing - 72,543 ( 70,584) ( 46,879) ( 43,667) Net benefit after financing Total - ( 53,677) 15,805 60,936 71,317 Incremental - ( 53,677) 15,805 60,936 71,317 Income taxation Income taxes paid - - - 8,618 34,761 Net benefit after financing and taxes Total - ( 53,677) 15,805 52,318 36,556 Incremental - ( 53,677) 15,805 52,318 36,556 Financial rate of return to all resources engaged = 14 percent' Financial rate of return to equity before income taxes = 16 percentb Financial rate of return to equity after taxes = 13 percentc Source Tables 5-2 and 5-4 a Calculated from the incremental net benefit before financing. For details about the methodology of the computation, see chapter 9 b Calculated from the incremental net benefit after financing. c Calculated from the incremental net benefit after financing and taxes first the income statements and then the sources-and-uses-of-funds state- ments. Only the rate of return is usually reported. Were the table itself to be used in a project report, it might be desirable to group the entries so that related items are not separated. The first financial rate of return to be determined is the financial rate of return to all resources engaged, which is a measurement of the financial viability of an enterprise. It is based on the incremental net benefit before financing. In the South Nyanza example, the rate of return to all re- sources engaged, assuming a thirty-year life for the project, is 14 percent. When all the elements that enter into the derivation of the incremental net benefit before financing are revalued to reflect economic values (as discussed in chapter 7) and any transfer payments are taken out, the 212 FINANCIAL ASPECTS OF PROJECT ANALYSIS incremental net benefit before financing becomes the basis for aggregat- ing the net economic benefit from the enterprise and carrying it into the economic accounts for the project. To obtain the incremental net benefit before financing, we begin with the revenue and direct subsidies received; these are taken from the income statements, which total to give the total inflow. The first two entries among the outflows are the cash operating expenses and the selling, gen- eral, and administrative expenses, also taken from the income statements. (At this point, if there were no direct subsidies, we would have the funds from operations; an alternative calculation of financial rates of return would therefore be to begin with the funds from operations, add any direct subsidies, and deduct any of the other elements of the outflow that are relevant.) Continuing with the outflow entries, we add duties and indirect taxes as shown in the income statements and add or subtract, as appropriate, the increase (decrease) in gross fixed assets and the increase (decrease) in inventories as shown in the sources-and-uses-of-funds state- ments. The result is the total outflow. Subtracting the total outflow from the total inflow provides the total net benefit before financing. Subtracting what would be the net benefit without the project (which, in the South Nyanza example, is nothing), we now reach the incremental net benefit before financing. The financial rate of return to equity before income taxes will be an important consideration to any potential private investors. It is also of concern if the enterprise is to be a financially responsible public sector enterprise that must demonstrate the good use it makes of resources put at its disposal. The return to equity before income taxes will help the project analyst judge the attractiveness of the proposed enterprise to potential investors and to determine if the financing plan will give rise to undue windfall profits. It may also help in deciding what special tax holiday or other exemption may be justified. For the South Nyanza example, the return on equity before income taxes is 16 percent. To determine the return to equity before income taxes, we need to calculate the incremental net benefit after financing, and to reach this we add or subtract the financing elements shown in the sources-and-uses-of-funds statements, indicating the sign in the account as we proceed. Note the inclusion of accounts payable and accounts receivable as part of the financ- ing. Because a decrease in accounts receivable increases the funds avail- able to the enterprise, it is decreases that are added to obtain the net financing. The heading on these entries has been reversed from that in the sources-and-uses-of-funds statements to indicate that decreases are to be added and increases subtracted. Finding the algebraic total gives the net financing, and subtracting that from the net benefit before financing gives the total net benefit after financing. Subtracting the without-project net benefit after financing (in this case, nothing), we reach the in- cremental net benefit after financing. Finally, we determine the financial rate of return to equity after taxes, which is based on the incremental net benefit after financing and taxes. For FINANCIAL ANALYSIS OF PROCESSING INDUSTRIES 213 the South Nyanza example, it is 13 percent. To determine the in- cremental net benefit after financing and taxes, we deduct income taxes from the net benefit after financing and subtract the without-project amount (in this case, nothing). This is the flow that will accrue to the equity owners after the enterprise has met its tax obligation. It is, of course, this flow that is of most concern to potential investors, and so the rate of return to equity after taxes is an important measure on which to base judgments about the incentives to invest in an enterprise. �� С' ^��: _ 'Г �$д Р ` . +�г Vv . гJ�; �'; '�! л , г� � _ r �;�r,�;ле.э� �.. � , � • л. _ �. _ _=_ �ц�" �ч � �;нl м . �%�.Ji.� • г � ,?. I � � ' `,/��+'. `v • .,�дд.;. . ' = ��,рΡлв�Т' _ ajF" . 7t �^s= � .. _�� ' _� \ г.;\-� L �� '�� 'г: _ � •' , �S . �• � 5 . , + !� �� „ - r�- ' - . _ ,,�,- - у ;� -.э� ' . , �г�"�,� � � . • '~ „�'�*w`� J . � 1 f . 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This will permit the government to plan for the capital investment in the project and to ensure that sufficient government funds will be available to meet the recurrent cost of the project. By tracing the foreign exchange flow generated by the project, the analyst can estimate the effect of the project on the balance of payments. The proportion of the cost and the proportion of the new benefit to be recovered by the government from the project beneficiaries should be estimated. It may be desirable, too, to determine how the cost of the project could equitably be allocated among the various groups that will benefit from it. The primary issue analysis of government receipts and expenditures addresses is whether the project will generate sufficient funds to reim- burse the government for the resources expended on the project. The analysis should treat the government as a distinct financial entity and should focus on inflows and outflows to and from governmental budget- ary and extrabudgetary accounts to anticipate the amount and timing of project needs from government sources. Such an analysis permits Facing page: Preparing land for swamp rice in Senegal. 215 216 FINANCIAL ASPECTS OF PROJECT ANALYSIS careful consideration of the implications a project has for government finance to meet not only the initial investment needs of the project but also its recurrent cost. Too often inadequate attention is paid to recurrent cost, and then budgetary stringencies starve a project for funds-greatly reducing its efficiency, leading to a waste of resources, and dashing the expectations of farmers and others who participate. It is common in agricultural projects that user charges or benefit taxes assessed on the project beneficiaries are insufficient both to recover the capital investment in the project and to pay all the operation and mainte- nance costs of the project. This might be the case in an irrigation project, for example, in which water charges are less than the amount the govern- ment incurs for capital repayment and operating the system or in which a program to increase production makes no charge for the services of agricultural extension agents. Sometimes other revenues arising from the project will be sufficient to reimburse the government for its costs. Such might be the case if the project increased agricultural production that is destined for export and is subject to an export tax. In many instances, however, not enough of the benefit from the project will be captured through charges or by the workings of the fiscal system to reimburse the government fully. In these instances, the difference will have to come from taxes levied elsewhere in the economy or through inflation. Whether this is to be the practice or not is a policy decision; one consideration may be that poor farmers are entitled to some income transfer through an agricultural project. The point of the analysis is not to say that the project beneficiaries must pay enough to cover all the costs of the project, both capital and recurrent. It is to say that the fiscal effects of the project need to be traced so that a conscious decision can be made about reimbursement of cost incurred by the government. Because of problems associated with budgetary stringencies, in many projects in which not all the costs are to be recovered from charges levied on project beneficiaries, the beneficiaries may still be charged enough to pay the recurrent cost of the project. This frees the project from depen- dence on year-to-year budget appropriations that may be subject to sudden cuts and decrease the efficiency of project implementation. The importance of anticipating future recurrent expenditure goes much beyond the individual project analysis, of course. Any one proj- ect-unless it is very large relative to the government budget-would not impose a serious burden for recurrent expenditure. All development investments together, however, may well lead to significant recurrent government expenditure. As a general rule of thumb, in developing countries capital expenditures tend to give rise to between 10 and 15 percent of their value in recurrent costs. Moreover, as the nature of development programs in many developing countries has tended to shift more and more toward projects that do not generate revenues sufficient to reimburse the government for recurrent cost, these expenditures have tended to grow rapidly. One result has been a persistent tendency to underestimate the burden of recurrent cost. EFFECTS ON GOVERNMENT BUDGET 217 The elements of the flows that affect government receipts and expendi- tures vary from project to project, and some may not always be obvious. They can, however, conveniently be cast in the form of a government cash flow account valued at market prices. Inflows will include user charges levied on project beneficiaries, new tax revenues generated as a result of the project investment, debt service for loans made to project partici- pants, the surplus or profit made on sales of the project or on services provided, and receipts from foreign loans made to help finance the project. Expenditures will include the initial capital expenditure on the project, including direct expenditure on such items as dams and canals; loans to project participants; equity positions taken in a processing industry; recurrent costs of the project in whatever guise they occur, whether operation and maintenance, general administration, or some other form; and debt service, including commitment fees on any foreign loans received to support the project. The analysis includes among the government expenditures related costs needed to make the project effec- tive (such as the costs of new roads or other infrastructure facilities) because, although these may not be the responsibility of the project management, they are costs incurred for the project and would appear in the project accounts when they are aggregated as discussed in chapter 8. Many agricultural projects will have an effect on the balance of pay- ments, so it may be desirable to do a separate analysis of the project'- foreign exchange effects in a foreign exchange flow account. Analysis of project effects on government receipts and expenditures can be illustrated by an example drawn from the South Nyanza Sugar Project, the same project used in the last chapter to illustrate the finan- cial analysis of processing industries. As before, the general headings that might be expected to appear in most analyses of this kind will appear in italic type in the text. Government Cash Flow The government cash flow account for the South Nyanza Sugar Project is excerpted in table 6-1. There is a problem about whether to make government cash flow projections in constant or current terms. For financial planning by the treasury and other government agencies, a current projection is much preferred, even though this involves projecting the inflation rate both domestically and worldwide. [A projection of worldwide inflation for capital goods is available in Price Prospects for Major Primary Commod- ities (World Bank 1982a).] But projecting inflation is difficult at best, and when done for more than just a few years it is of very little usefulness. In the South Nyanza project, therefore, the analyst chose a useful com- promise: he projected the government cash flow in current terms for the five years of the investment phase during which the sugar factory was to be built. Then, from year 6 onward, he projected the cash flow in constant 218 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 6-1. Government Cash Flow, South Nyanza Sugar Project; Kenya (thousands of KSh) Project year Item 1 2 6 7 16 Inflow Loan receipta World Bank 19,480 35,280 - - - African Development Bank 3,540 13,710 - - - Total loan receipt 23,020 48,990 - - - Taxes Sugar exciseb - - 63,771 79,043 127,260 Molasses exciseb - - 142 176 277 SNSC incomec - - - - 54,853 Other duties and taxesd 15,462 27,625 15,675 13,775 17,069 Debt service receipt Interest payment - 270 13,437 12,748 6,547 Loan commitment fee 984 965 - - - Repayment of principal - - 6,563 6,563 6,563 Dividends' - - - - 63,691 Total inflow 39,466 77,850 99,588 112,305 276,260 Outflow Equity in sNsc 54,150 71,250 - - - Loans to sNscr - 2,570 - - - rimancing of Kenya Sugar Institute and trainingg 1,828 5,555 5,563 5,726 5,451 Grant to National Sugar Research Institute" 297 3,393 2,371 2,470 2,371 Road construction and maintenance' 4,430 17,294 4,996 4,996 4,996 Subtotal 60,705 100,062 12,930 13,192 12,818 Debt service payment Interest World Bank 1,751 4,930 49,750 48,505 37,300 African Development Bank 283 1,380 3,287 2,922 - Loan commitment fee World Bank 1,411 1,145 - - - African Development Bank 316 213 - - - Repayment of principal World Bank - - 13,833 13,833 13,833 African Development Bank - - 4,565 4,565 - Total debt service payment 3,761 7,668 71,435 69,825 51,133 Total outflow 64,466 107,730 84,365 83,017 63,941 Net cash flow Current surplus (deficit) (25,000) ( 29,880) 15,223 29,288 212,309 Cumulative surplus (deficit) (25,000) ( 54,880) (13,582) 15,706 1,313,167 KSh Kenyan shillings Note- In current prices for years I through 5 (1977-81), thereafter, in year-5 (1981) constant prices. Parentheses indicate negative numbers. Source' Adapted from World Bank, "Kenya Appraisal of the South Nyanza Sugar Project," 1418-KE (Washington, D C, 1977, restricted circulation), annex 20, table 17 a The disbursement of the German and Indian suppliers' credit and loans from the European Investment Bank, East African Development Bank, and the U S Export-Import (Exim) Bank have been assumed to be directly to the South Nyanza Sugar Company (sNsc) and not through the government. b The excise tax per ton is in constant 1976 prices and is assumed at KSh 1,000 for sugar and KSh6 for molasses for years I through 5, adjusted to current terms by using a factor of EFFECTS ON GOVERNMENT BUDGET 219 terms at year-5 prices. This avoided making a long-term projection of inflation. (Note that this would not be a suitable format if the cash flow were to be discounted as discussed in chapter 9.) The analyst also chose to include in his cash flow table a total column after year 5 for the first five years (not reproduced in the excerpt in table 6-1). The government cash flow is projected for sixteen years, long enough to trace the effect of all the financial transactions except the repayment of the World Bank loan. The government cash flow account is divided into cash inflow and cash outflow. The first inflow is the loan receipt obtained from abroad to support the project. In the case of the South Nyanza project, the govern- ment of Kenya received loans from the World Bank and the African Development Bank for the project. Other loans were made by suppliers and by other international lending agencies that dealt directly with the South Nyanza Sugar Company. The flows from these loan transactions, since they did not go through the government, do not show in the govern- ment cash flow. Next in the table are the taxes. The South Nyanza project is expected to generate new tax revenues from the sugar excise tax collected at the factory gate and a similar excise tax on molasses; com- pany income tax; and other taxes that include import duties on mate- rials, machinery, vehicles and equipment, excise duty on capital and current inputs, and income taxes on staff salaries. Next comes the debt service receipt from the South Nyanza Sugar Company for the loan it has received from the government. The debt service is broken down into the interest payment, loan commitment fee, and repayment of principal. Fi- nally, there is the transfer of company profit that is made to the govern- ment in lieu of dividends. Some proportion of this profit would by agree- ment customarily be reinvested in company expansion. Had there been any user charges, these, too, would have been included in the cash inflow. The first entry in the cash outflow is the equity participation the gov- ernment contributed to the South Nyanza Sugar Company, followed by loans to the company. These, in effect, constitute the capital cost contrib- uted from the government budget to the company operation. Two other outflows are the financing for the Kenya Sugar Authority for training not directly administered by the company, including overseas university education in business management and sugar technology and participa- tion in international symposia and conventions, and a grant to the 32.2 percent in year 4 (1980) and 41.4 percent in year 5 (1981) and thereafter. c. Values are in constant 1976 prices adjusted by 41.4 percent to year-5 (1981) constant prices. d. Includes import duties on materials, machinery, vehicles, and equipment; excise taxes on capital and current input; and income tax on staff salaries. The values are in constant 1976 prices adjusted by 41.4 percent to year-5 (1981) constant prices. e. It is assumed that sNsc dividends to the government will be 95 percent of sNsc net profits after tax, expressed in year-5 (1981) constant prices. f. The on-lending margin to sNsc has been assumed to be 1.5 percent. g. Includes the incremental cost to the Kenya Sugar Authority arising from the project and the cost of training and conference participation not included in the sNsc accounts. h. Incremental cost to the National Sugar Research Institute arising from the project. i. Includes the cost of roads needed for the project not included in sNsc nucleus estate. 220 FINANCIAL ASPECTS OF PROJECT ANALYSIS National Sugar Research Institute to reimburse it for incremental ex- penses arising from the project. This is followed by road construction that is a part of the project cost to be paid directly by the government and not channeled through the company. Then comes the debt service payment the government must make as a result of the project. This includes interest, loan commitment fee, and repayment of principal to the World Bank and the African Development Bank. The difference between the cash inflow and the cash outflow gives the cash current surplus (deficit), which in the South Nyanza case is negative through project year 3 and positive thereafter. The cumulative surplus (deficit) indicates how long it will be before the government recovers its net expenditure on the project in undiscounted terms-six years in the South Nyanza example. In other projects, of course, both the current and the cumulative surplus (deficit) might remain negative throughout the life of the project. Foreign Exchange Flow The foreign exchange flow generated by the South Nyanza project is calculated in table 6-2. Table 6-2. Foreign Exchange Flow, South Nyanza Sugar Project (thousands of KSh) Project year Item 1 2 6 7 16 Inflow Loan receipt Suppliers' credit-Germany 17,200 27,400 - - - Suppliers' credit-India 15,500 24,750 - - - World Bank 19,480 35,280 - - - European Investment Bank 33,400 53,200 - - African Development Bank 3,540 13,710 - - - East African Development Bank 6,070 9,670 - - - Exim Bank 7,900 10,380 - - - Total loan receipt 103,090 174,390 - - - Foreign exchange value of sugar production' - - 248,501 308,009 495,000 Export of molassesb - - 8,261 10,235 16,114 Total inflow 103,090 174,390 256,762 318,244 511,114 Outflow Foreign exchange component of Agriculture 15,674 15,096 30,304 51,132 45,522 Sugar factory 68,832 107,162 51,982 14,275 19,325 General management and administration 2,251 2,814 5,442 5,311 5,442 Road construction and maintenance 3,532 13,676 3,612 3,612 3,612 Housing and social amenities 4,223 4,735 - - - Research 655 2,470 1,622 2,469 1,622 Training 120 294 648 648 648 EFFECTS ON GOVERNMENT BUDGET 221 Table 6-2 (continued) Project year Item 1 2 6 7 16 Kenya Sugar Authority 617 1,825 1,634 1,814 1,572 Management fee - - 2,410 3,240 6,940 Total foreign exchange component 95,904 148,072 97,654 82,501 84,683 Debt service payment Interest Suppliers' credit-Germany - - 3,509 2,946 - Suppliers' credit-India - - 3,190 2,678 - World Bank 1,751 4,930 49,750 48,505 37,300 European Investment Bank 2,004 5,196 5,917 5,260 - African Development Bank 283 1,380 3,287 2,922 - East African Development Bank 668 1,732 1,879 1,566 - Exim Bank 771 1,645 780 388 - Total interest payment 5,477 14,883 68,312 64,265 37,300 Loan commitment fee World Bank 1,411 1,145 - - - African Development Bank 316 213 - - - Exim Bank 69 17 - - - Total commitment fee 1,796 1,375 - - - Repayment of principal Suppliers' credit-Germany - - 7,050 7,050 - Suppliers' credit-India - - 6,381 6,381 - World Bank - - 13,833 13,833 13,833 European Investment Bank - - 10,956 10,956 - African Development Bank - - 4,565 4,565 - East African Development Bank - - 2,846 2,846 - Exim Bank - - 4,354 4,354 - Total repayment of principal - - 49,985 49,985 13,833 Total outflow 103,177 164,330 215,951 196,751 135,816 Net foreign exchange flow Current surplus (deficit) ( 87) 10,060 40,811 121,493 375,298 Cumulative surplus (deficit) ( 87) 9,973 258,251 379,744 3,080,980 Note: In current prices for years I through 5 (1977-81); thereafter in year-5 (1981) constant prices. Source: Same as table 6-1. a. Based on the foreign exchange element of the import substitution price of KSh3,897 per ton in constant March 1977 prices adjusted for inflation to KSh5,152 per ton in year 4 and KSh5,510 per ton from year 5 onward. b. Based on molasses price f.o.b. Mombasa of KSh463 per ton in year 4 and KSh495 per ton from year 5 onward. As in the case of the government cash flow, the question arises of whether to calculate the foreign exchange flow in constant or current terms. Matching his choice for the government cash flow, the analyst chose to project the foreign exchange flow in current terms for the five years of the implementation phase of the project while the sugar factory was to be built and then, from year 6 onward, in constant terms at year-5 prices. As before, this provided the treasury and other planning agencies with a current projection of the foreign exchange effects of the project for the first few years of its implementation but avoided a long-term projec- tion of inflation. Again, the analyst chose to carry out his calculations for 222 FINANCIAL ASPECTS OF PROJECT ANALYSIS sixteen years, long enough to trace all the financial transactions except repayment of the World Bank loan. The foreign exchange flow is derived by tabulating the inflow, deduct- ing the outflow, and obtaining the net foreign exchange flow. The first inflow is the loan receipt in support of the project. Note that the suppliers' credit and loans from several international agencies were received directly by the South Nyanza Sugar Company, so they do not show in the government cash flow examined in the previous section but do appear here. Then comes the foreign exchange value of the sugar production. This is the foreign exchange saved as a result of substituting domestically produced sugar for imported sugar. The last inflow listed is the foreign exchange earned from the export of molasses. Foreign exchange outflows include the foreign exchange component of the various aspects of project implementation, including equipment and materials purchased from abroad and management fees. The other ma- jor component of the foreign exchange outflow is the debt service payment for loans received from abroad. This includes interest, any loan commit- ment fee, and repayment ofprincipal to the suppliers of equipment and the international agencies that lent to support the project. Subtracting the total outflow from the total inflow gives the net foreign exchange flow, which is reported in two variations: the current surplus (deficit) and the cumulative surplus (deficit). In part because of the financ- ing available, the foreign exchange effect of the South Nyanza project is positive every year except the first. Cost Recovery When governments invest in projects that increase the incomes of individual farmers, the question arises about how much of the govern- ment expenditure should be recovered from the project beneficiaries. Only through appropriate cost recovery policies can governments recoup the money expended on a project for investment in other projects that will benefit other members of the society. To the extent that the cost of a project is not recovered, some part of the project benefit individuals receive represents a subsidy paid by others in the society who did not benefit from the project. There are two important issues to be addressed in formulating cost recovery policy. One is the proportion of the cost expended on a project to be repaid. The other is the proportion of the benefit received by indi- viduals (which may be far higher than the cost) to be recovered through direct charges and such indirect means as increased tax revenue. Project analysis, however, clearly cannot make the policy decision. Moreover, attempts to determine the proportion of government expenditure and individual benefit to be recovered under various alternative policies very quickly run into great practical difficulties. These involve estimating values, often imputed values, and more theoretical economic issues, so EFFECTS ON GOVERNMENT BUDGET 223 that in the end cost recovery computations are of necessity more indica- tive than precise. Even so, cost recovery estimates based on sound eco- nomic principles can greatly improve understanding of the issues and improve the efficiency and equity of cost recovery policies. Some aspects of cost recovery have little to do with the specifics of computation. Many countries have well-established policies about such things as water charges or taxes, policies that may not be politically possible to change all at once. Other considerations have to do with the project itself. Those projects which provide reliable service to farmers are more likely to have a better record on cost recovery than projects in which farmers feel services are poor and unreliable and, to that extent, not worth paying for. In the final analysis, any cost recovery policy must be a political decision; it cannot be divorced from the broader sectoral and social setting. Any approach to cost recovery must be flexible and based on a recognition that what might be a good policy decision at one place or at one time is not necessarily the best decision at another place or time. Problems of cost recovery in agricultural projects tend to be prominent in irrigation projects because these projects often are very expensive and bring proportionally large increases in income to the farmers who bene- fit. Much of the discussion of cost recovery, therefore, has centered around water resource projects, and the examples used in this section to illustrate methods of computation will be drawn from an irrigation project in India. The discussion here must necessarily be very general; more detailed information can be found in "Irrigation Water Charges, Benefit Taxes, and Cost Recovery Policies" (World Bank 1982b). Objectives of cost recovery Three basic objectives are involved in considerations of cost recovery issues: (1) economic efficiency, (2) income distribution, and (3) public saving. ECONOMIC EFFICIENCY. The first objective concerns the level and struc- ture of the prices to be charged-in irrigation projects, the price for water. The objective is to minimize waste and to allocate water opti- mally to maximize the net benefit from the project to the economy. The best way to do this would be through a price that would be equal to the contribution the water would make to increased output-an "efficiency price." This theoretical ideal is very rarely, if ever, met. It would require sale of water on a volumetric basis, which would lead to difficult prob- lems in practice and would require estimating the contribution of water. But even a nominal price for water, perhaps one based on an acceptable if less than perfect measurement technique, would offer users an incentive to eliminate at least some of the conspicuous waste and overwatering that occur when farmers treat water as a free good. This, in turn, could reduce drainage and salinization problems. 224 FINANCIAL ASPECTS OF PROJECT ANALYSIS Even if it were possible to charge farmers an optimal economic price, this might not be compatible with objectives of income distribution and public saving and investment. Hence, other criteria of assessing charges will have to be considered to ensure an equitable income effect from the project and an adequate recovery of project costs by charges that prospective beneficiaries can afford to pay and that still leave them adequate incentive to participate. Some recovery of benefits and costs will usually come from existing general taxes, such as an export tax or an income tax. But this recovery method is not geared to the circumstances of the particular project and is often unsatisfactory from the point of view of either income distribution or public savings. Moreover, capturing a larger part of the benefits and recovering more of the costs of a project through an increase in general taxation also affects those who do not directly benefit from the project. Hence, any measure to recover costs and benefits in addition to water pricing and existing general taxes should be selective and affect, to the greatest extent possible, only the project beneficiaries. These measures are usually called "benefit taxes." The most common form is a betterment levy assessed against the land benefited and perhaps varied according to the different crops grown. INCOME DISTRIBUTION. The second objective of a cost recovery policy is to collect charges equitably and in line with national policy for income distribution. It may be desired to charge small farmers proportionately less than large farmers in the same project. Thus, specific taxes designed to capture part of the benefit of a project should take into account differences in income level and in the ability of beneficiaries to pay. Benefit taxes should allow for the quite different amounts of net benefit a project generates on farms quite similar in size and other characteristics. The taxes will have to be set taking into account disincentives, tax evasion, and the cost of collection. In irrigation projects, in practice only the broadest income distribution measures are implemented. A ceiling may be set on the total area an individual family may irrigate, for example, and an effort is usually made to ensure that small farmers at least do not pay a higher proportion of their benefit from the project than do larger farmers. PUBLIC SAVING. Most governments in developing countries are short of financial resources for development. Consequently, it may be desirable for the government to collect more resources than would be generated solely from efficiency pricing (which, in any case, is generally impracti- cal) or from recovering only the cost of the project and no part of the net benefit. Not only would this make the projects financially self- supporting, but it would also enable governments to undertake addi- tional rural development projects that would reach other members of the society. But farmers participating in a project may be poor. To recover more than the cost of the project may therefore be unacceptable, and it may be desirable to recover less. EFFECTS ON GOVERNMENT BUDGET 225 Setting the level of water charges and benefit taxes As the discussion to this point has indicated, the level at which to set water charges and benefit taxes will depend on a broad range of consid- erations. First, some estimate must be made of the net benefit received from the project by various participants. Then a system of charges and taxes must be established that captures an acceptable proportion of the benefit generated by the project while still meeting criteria of efficiency, income distribution, and equity. The level of charges and taxes must take into account similar levies in other areas and the political feasibility of charging a different amount in the project area, the disincentive effects of a benefit tax, and the administrative problems of tax collection. Benefit taxes should be designed to minimize the adverse effects these taxes may have on the production and consumption decisions of the farmers and others in the economy. It might be possible in some cases, for example, to recover costs by selling farm inputs to project beneficiaries at prices higher than those paid by others, or to purchase the output from benefi- ciaries at prices lower than otherwise would be paid-that is, to establish a monopolistic marketing margin. Such discriminatory taxes may in- duce choice of the wrong crops by farmers, although these taxes may be impossible to avoid completely. Volumetric sale in some form acceptable to farmers and project-specific betterment levies are generally better options. The extent and manner of cost recovery directly affects the financial cash flows of the farmer, the project organization, and usually more than one government agency. Cost recovery can also affect the contribution an irrigation project will make to increasing national income. If cost recov- ery plans impose too heavy a burden on the farmers, the farmers may have insufficient incentive to participate fully in the project, and the anticipated output of the project will not be realized. In contrast, if cost recovery levels are set too low, the project organization may have too small an operation and maintenance budget-whether it is financed by water charges paid by farmers or by a government subsidy-so that water deliveries to farmers may be insufficient and unreliable, and pro- duction again could suffer. The total benefit arising from the project sets a theoretical upper limit to the amount of revenue that can be collected from water charges and benefit taxes, but the actual amount collected will always be less-and usually much less-than the total benefit arising from the project. This is true simply because it is necessary to allow for errors of measurement and for the desire to increase the income of the poorest farmers. The lower limit of charges to be collected cannot be stated arbitrarily. A rule of thumb followed by many governments, however, is to attempt to establish water charges and benefit taxes that will at least recover the operation and maintenance cost. This will avoid an outright drain on current government revenues by the project. It will also reduce the 226 FINANCIAL ASPECTS OF PROJECT ANALYSIS likelihood of problems arising from delays in receiving operation and maintenance funds caused by budget stringencies. There is another advantage. Where systems receive their operation and maintenance funds from the project beneficiaries, and the beneficiaries have a signifi- cant influence on the operation of the system (often through an appropri- ate local farmers' organization), the systems generally are fairly well managed and maintained. Past experience in World Bank projects sug- gests that cost recovery as a percentage of incremental net cash income rarely exceeds 30 to 35 percent. Once established, cost recovery charges-whether water charges or benefit taxes-should be indexed so they can change in response to changing costs and to inflation. Because in new projects it is likely that farmers will need several seasons to learn to use new water efficiently, a grace period is probably appropriate during which the full water charges and benefit taxes can be phased in. Measuring cost and rent recovery Two measures are usually calculated to help form judgments about cost recovery. They are the cost recovery index, which gives an idea of what proportion of public expenditure on a project will be recovered directly from the beneficiaries and through taxes collected off the farm, and the rent recovery index, which gives an idea of what proportion of the total benefit will be recovered from the project beneficiaries and from other sources. These ratios are descriptive only-they should only sup- plement, not substitute for, an analysis of proposed water charges as they bear on efficiency, income distribution, public sector savings, and such factors as tax disincentives, costs of tax collection, broader sectoral considerations, and the political implications of any charge or tax. Fur- thermore, both measures depend on several values that are impossible to establish with precision, so that decisions based upon them must be treated with great caution. COST RECOVERY INDEX. The first measure of cost recovery is the cost recovery index. It is: Present worth of incremental water charges + present worth of incremental benefit taxes Present worth of incremental public sector outlays The cost recovery index is calculated using constant market prices. The appropriate discount rate is the economic opportunity cost of capital. An example of how to calculate the cost recovery index is given in table 6-3, which is drawn from the Maharashtra II Irrigation Project in India. The first element is an estimate of the present worth of capital cost (per hectare of net cultivable "command area"-the area that can be irri- gated by a particular group of irrigation works). This is based on the same cost estimates for the project as are used for other parts of the EFFECTS ON GOVERNMENT BUDGET 227 Table 6-3. Total Cost Recovery Index, Bhima Irrigation Scheme, Maharashtra II Irrigation Project, India (Rs per hectare, constant 1979 prices) Item Amount Present worth of capital cost (per hectare of net cultivable command area)" Irrigation infrastructure 18,550 Supporting works 1,850 Total 20,400 Annual financial equivalent (per hectare of net cultivable command area) Irrigation infrastructureb 1871 Supporting worksc 301 Operation and maintenance 100 Total 2,272 Cost recovery (under existing charges) Direct Incremental water charge 258 Incremental benefit taxd 306 Indirect receipts' 95 Total 659 Total cost recovery index (percent)' 29 Rs Indian rupees. Source: Adapted from World Bank, "India, Staff Appraisal Report, Maharashtra Irriga- tion II Project," vol.i, "Main Report," 2529a-IN (Washington, D.C., 1979; restricted circula- tion), pp. 83-84. a. For the method of calculating present worth, see chapter 9. b. Annuity for recovery over fifty years at 10 percent interest rate. Calculated by multi- plying the present worth of the capital cost of the irrigation infrastructure by the capital recovery factor for fifty years at 10 percent, which is 0.100 859, to give Rsl,871 (18,550 x 0.100 859 = 1,871). c. Annuity for recovery over ten years at 10 percent interest rate. Calculated by multi- plying the present worth of the capital cost of the supporting works by the capital recovery factor for ten years at 10 percent, which is 0.162 745, to give Rs301 (1,850 x 0.162 745 = 301). d. Incremental benefit taxes include a tax to recover the capital cost of the supporting works, amounting to Rs301 per hectare (see note c above), and an incremental land revenue assessment of Rs5 per hectare, or a total of Rs306 (301 + 5 = 306). e. Indirect cost recovery receipts average Rs40 per hectare for the purchase tax on sugarcane and Rs55 per hectare for the sales tax on cotton and oilseeds, or Rs95 per hectare (40 + 55 = 95). f. Total cost recovery under existing charges divided by annual financial equivalent per hectare of net cultivable command area multiplied by 100 (659 - 2,272 x 100 = 29). project analysis. Next, the annual financial equivalent (per hectare of net cultivable command area) is determined. For capital items-in this in- stance, the irrigation infrastructure and the supporting irrigation works-this value is calculated by multiplying the present worth of the capital cost by the capital recovery factor for the appropriate period and discount rate. [For capital recovery factors, see Gittinger (1973) or a similar set of compounding and discounting tables.] In this Maharashtra example, the irrigation infrastructure was assumed to have a life of fifty years, and the opportunity cost of capital was taken to be 10 percent, so 228 FINANCIAL ASPECTS OF PROJECT ANALYSIS the capital recovery factor for fifty years at 10 percent, or 0.100 859, was applied to the present worth of the irrigation infrastructure. The sup- porting works were taken to have a life of only ten years, so the capital recovery factor for ten years at 10 percent, or 0.162 745, was applied to them. The operation and maintenance charge, of course, is an annual charge, so it may be taken directly. Next the cost recovery is determined, in this case calculated assuming that existing charges will continue. The Maharashtra project is typical of many irrigation projects in that part of the cost recovery will come directly through water charges and a benefit tax, and part of the cost recovery will come from an indirect charge in the form of an excise tax on incremental sugarcane production and in- cremental sales tax revenues from marketing cotton and oilseeds. The total cost recovery index, then, is simply the total cost recovery divided by the total annual financial equivalent and multiplied by 100, which in this instance gives 29 percent (659 + 2,272 x 100 = 29). There are variations that may be calculated, depending on the need for information on which to base cost recovery charges and benefit taxes. In the case of the Maharashtra project, for example, table 6-3 illustrates computation of the total cost recovery index, which includes as part of the cost recovery both the direct recovery through water charges and benefit taxes and the indirect recovery through excise and sales taxes. An alternative would be to calculate the direct cost recovery; that is, the amount recovered directly from the farmers themselves. In this instance the direct water charges and benefit taxes come to Rs564 per hectare (258 + 306 = 564), which would be divided by the total annual financial equivalent of Rs2,272 per hectare and multiplied by 100, so that the direct cost recovery index would be 25 percent (564 - 2,272 x 100 = 25). (The symbol for Indian rupees is Rs.) The cost recovery index in various forms may then be used as a basis for conclusions about cost recovery policy. The effect of various levels of water charges and benefit taxes can be tested until a decision is reached about a suitable level and combination of these given such other public policy considerations as equity and the amounts charged elsewhere in the country. RENT RECOVERY INDEX. The other cost recovery measure commonly calculated is the rent recovery index. It is based on projected farm budgets that are similar to those developed in chapter 4 but that have significant differences in that they include imputed values for labor, management, return to capital, and risk. In the illustrative calculation that follows, the rent recovery index for beneficiaries will be used to estimate the proportion of the benefit received by project beneficiaries that is recovered by the public authorities. The rent recovery index is: Incremental revenue from water sales + incremental benefit taxes Incremental economic rent accruing to project beneficiaries EFFECTS ON GOVERNMENT BUDGET 229 Since the rent recovery index is generally computed to be used in forming a judgment about the amount of water charges and benefit taxes, it is not a discounted measure; rather, it is done for one year at the full development period. It is based on market prices. In a general sense, the rent recovery index may be thought of as being based on the farmer's "ability to pay," his "capacity to pay," or his "repayment capacity." To calculate the rent recovery index, however, the more formal concept of "economic rent" is used. Economic rent is the surplus remaining after beneficiaries receive the rewards necessary to attract physical inputs, labor, entrepreneurship, and the willingness to bear risk. Economic rent is allied to the more familiar concept of rent as a payment for use of a capital item, but it is quite distinct from this more common use of the term "rent" and should not be confused with it. In the case of an irrigation project, to calculate the economic rent accruing to a beneficiary, one starts with the incremental gross value of farm production, from which is deducted all incremental cash payments, incremental depreciation of farm assets, the imputed value of family labor and of management, a return on the family's own incremental capital, incremental general taxes, and an allowance for additional risk and uncertainty. Incremental water charges and incremental benefit taxes related to the project are not deducted. It will immediately be seen that estimating economic rent is not easy and is subject to a large margin of error. The various noncash and imputed values of costs cannot be determined with precision; they inevitably involve substantial judg- ment. It is necessary to make some estimate of this sort, however, to judge whether a sufficient proportion of the benefits received by farmers in the project is being recovered because these same elements must be considered however benefits may be measured. An example of the computation of the rent recovery index is found in table 6-4, which is drawn from the same Maharashtra irrigation project used as an example in the previous subsection. The computation starts with the gross value of farm production at farm-gate prices without sales taxes. Of this, sales without the project amount to half, but as the family's income rises the proportion of sales rises sharply. From the gross value of farm production is deducted the cash production cost, and this gives the net benefit. This is consistent with the net benefit as defined in chapter 4 and as illustrated by the farm budget in tables 4-18 and 4-19, except for any off-farm income the family may receive. The net cash income is determined by subtracting the cash production cost from the sales. The net cash income can be compared later with any incremental water charge or benefit tax levied. Next a group of imputed values are deducted. The first of these is depreciation. Since the rent recovery index is computed on the basis of one year at full development, depreciation must be deducted as a cost. Then an estimate of the imputed value of family labor is deducted. This is an estimate of the wage necessary to induce the family to operate its farm. In practice, it is suggested that the analyst take the weighted average of the seasonal market wage as a proxy. Next comes an estimate 230 FINANCIAL ASPECTS OF PROJECT ANALYSIS Table 6-4. Rent Recovery Index, Full Development, 5-Hectare Farm, Light Soils, Bhima Scheme, Maharashtra Project (Rs, constant 1979 prices) Amount Without With Incre- Item project project mental Gross value of farm production at farm-gate prices without sales taxes 7,500 33,380 25,880 Sales 3,750 28,380 24,630 Cash production cost' (2,690) (11,690) ( 9,000) Gross value less cash production cost equals net benefit 4,810 21,690 16,880 Sales less cash production cost equals net cash income 1,060 16,690 15,630 Net benefit less Depreciationb 0 0 0 Imputed value of family labor ( 720) ( 1,350) ( 630) Imputed value of management services' ( 70) ( 1,030) ( 960) Imputed return on own capital' 0 0 0 Allowance for risk and uncertainty' (3,380) (10,010) ( 6,630) General taxesf 0 0 0 Equals economic rent (surplus) 640 9,300 8,660 Economic rent as a percentage of netbeneftg 13 43 51 Incremental water charges" - - 1,290 Incremental benefit taxes' - - 1,530 Total incremental direct charges and benefit taxes' - - 2,820 Rent recovery index (percent)k - - 33 Source: Same as table 6-3. a. May include some payment in kind for labor. b. Since the farmer has few physical assets other than land, no depreciation was assumed. c. An imputed value of management services equivalent to 10 percent of the net benefit less the imputed value of family labor and the allowance for risk and uncertainty rounded to the nearest RslO. For the with-project situation, this amounts to Rsl,030 rounded to the nearest Rsl0 {0.1[21,690 - (1,350 + 10,010)] = 1,033}. d. Since the family has few physical assets, no imputed return to the family's own capital was assumed. e. Some studies of farmers' behavior show that a simple approach can be adopted to take account of the farmer's risk aversion. An allowance for risk and uncertainty is estimated based on the coefficient of variation of the gross value of farm production-the standard deviation divided by the mean-and a measure of farmers' risk aversion. The formula used is RA = EV X n X V, where RA is the risk allowance, EV is the expected value, v is the coefficient of variation, and n is a factor that expresses farmers' risk aversion. The studies indicate that the farmers' choice of cropping patterns and production can be predicted for values of n in the interval between I and 2 and that n decreases when the farm size increases For this analysis, it is assumed that n = 1.5 for 5-hectare farms. For the project area, the coefficient of variation of gross returns under rainfed conditions is roughly 30 percent of the average value. It has been assumed that under the with-project conditions, the gross returns would vary within 20 percent of the net returns. The results were rounded to the nearest RslO. Following this approach, the allowance for risk and uncertainty in the with-project situation was esti- mated to be RslO,010 rounded to the nearest RslO (33,380 x 1.5 x 0.2 = 10,014). EFFECTS ON GOVERNMENT BUDGET 231 of the imputed value of management services. This is a very difficult estimate to reach. In practice, project analysts take an arbitrary amount. A common estimate is 5 to 10 percent of the net benefit. In the Maharash- tra project, however, the analyst took 10 percent of the net benefit less the imputed value of family labor and the allowance for risk and uncertainty. The imputed return on own capital is an estimate based on the in- cremental net value of assets financed by farmers out of their own savings and should reflect the rate of return that their funds could earn else- where. In the Maharashtra project, no imputed return on own capital was assumed because the family had relatively few physical assets. Other analysts, however, might at least have imputed a return to the family's own capital invested in land. The next imputed value deducted is the allowance for risk and uncer- tainty. This is extremely difficult to formulate conceptually and notori- ously difficult to estimate with confidence. Again, most project econo- mists use a rule of thumb-a common one is 10 percent of the gross value of farm production in the first line of the table. The project analyst in the Maharashtra project used a more sophisticated approach. He based his estimate on the standard deviation of farm production in the project area and on an estimated factor that expresses the farmers' risk aversion. (The details of this computation are given in note e of table 6-4.) Most project analysts probably will have some sense of the variability of farm produc- tion in the project area for which they are preparing the analysis, and they may even have some more formal estimate such as the standard deviation. This will provide a basis for estimating the allowance for risk and uncertainty, but it will have to be substantially modified in light of the analyst's judgment about the accuracy of the estimate of variability and the willingness of farmers in the project area to accept risk. The last imputed value deducted is an estimate of the general taxes the farmer pays. These are taxes that are not specific to the project as a benefit tax would be. General taxes might include, for example, income taxes or a land tax to raise general revenue that is not linked to the project nor to improvements arising from the project investment. When all these values have been deducted, the remainder is an esti- mate of the economic rent (surplus) accruing to the farmer. It is thus an estimate of the surplus remaining for the farmer after paying the rewards necessary to attract the physical inputs, labor, entrepreneurship, and willingness to bear risk necessary to operate the farm-the definition of f. No general taxes are expected to be levied. g. Economic rent divided by net benefit multiplied by 100. For the incremental net benefit this amounts to 51 percent (8,660 -- 16,880 x 100 = 51). h. Incremental direct water charges are Rs258 per hectare of net cultivable area, or Rs1,290 for the 5-hectare farm (258 x 5 = 1,290). i. Incremental benefit taxes include a tax of Rs30I per hectare to recover the capital cost of the supporting works and an incremental land revenue assessment of Rs5 per hectare, or Rs1,530 for the 5-hectare farm [(301 + 5) x 5 = 1,530]. j. Incremental water charges plus incremental benefit taxes. k. Total incremental direct charges and benefit taxes divided by economic rent multi- plied by 100 (2,820 + 8,660 x 100 = 33). 232 FINANCIAL ASPECTS OF PROJECT ANALYSIS economic rent above. The economic rent as a percentage of net benefit, the next entry in the table, relates economic rent to the net benefit received by the farmer, which for the incremental net benefit amounts to 51 percent (8,660 + 16,880 x 100 = 51). Next are entered the proposed incremental water charges and in- cremental benefit taxes that the farmer is expected to pay. Dividing the total of these by the economic rent gives the rent recovery index. This is an estimate of the proportion of the surplus the farmer receives over and above the minimum necessary to induce him to participate in the project that will be recaptured by the public authorities. In the case of the Maharashtra project, this recovery amounts to 33 percent of the eco- nomic rent [(1,290 + 1,530) + 8,660 x 100 = 33]. This discussion of the rent recovery index has highlighted the many elements of the estimate that can be approximate at best. Hence, the rent recovery index, although very useful as an aid for setting cost recovery policy, must be used with caution. As with the cost recovery index, there are variations of the rent recov- ery index that give insight into other questions about a project. A com- mon variation is to estimate the rent recovery index for the project (as opposed to that for the beneficiaries, as illustrated in table 6-4). For this the project rent must be estimated. Essentially the same elements are used as discussed above, except that the concept of the incremental benefit tax is expanded to include not only benefit taxes collected directly from the beneficiary but also taxes arising from the incremental output due to the project but collected off the farm. These include, in the case of the Maharashtra project, the excise tax on sugarcane and the sales tax on cotton and oilseeds. In other cases they might include an export tax or the net increase in a marketing board margin (technically, in the monopolis- tic marketing margin) arising from handling incremental production from the project area. In general, estimates of project rent are made for each major farm pattern, and the results are aggregated to the project level. Since the incremental benefit taxes include taxes and marketing margins arising off the farm, the project rent recovery index will be higher than the weighted average of the beneficiary economic rent re- ceived by the individual farmers. In the case of the Maharashtra project, for instance, the rent recovery index for the individual farm pattern analyzed in table 6-4-33 percent-rises to 40 percent for the Bhima scheme as a whole (including pattern farms other than the one repre- sented in table 6-4) because the additional taxes are included. Another variation of the rent recovery index is to calculate it, for either beneficiaries or the project, on a discounted basis. This provides a means to estimate on the basis of present worth the proportion of the benefit of a project captured by the public authorities. This is useful from a public policy standpoint, but is not a suitable basis on which to determine the level of water charges and benefit taxes at full development. From a public policy standpoint, one can then test varying assumptions about water charges and benefit taxes until a rent recovery index is reached that is considered to be equitable given the income of the farmers in the project and the charges levied elsewhere in the country. EFFECTS ON GOVERNMENT BUDGET 233 Joint Cost Allocation When a government undertakes to implement a multipurpose project, a problem arises about how to allocate the cost of the project among the various beneficiaries. The complication arises, of course, because there are joint costs in a multipurpose project, costs that cannot clearly be attributed to one purpose or another. A technique often used to allocate joint cost-especially in multipurpose water development projects, but by no means limited only to them-is that known as the "separable costs-remaining benefits" method. We will discuss joint cost allocation using market prices and as a financial problem, since this is by far the most common practice. The same techniques we will outline, however, can be applied to economic values, and in some cases this may be more appropriate. In the Senegal River Development Program we will use as an example for joint cost allocation, the prices for agricultural commodities were indeed taken not as the internal administered prices actually paid farmers but as the border prices at world market values-already a step away from strict financial analysis and toward economic values and the use of shadow prices. This was done because the major objective of the analysis was to determine a fair cost allocation among the participating nations, not to determine equitable financial charges to levy on benefiting farmers. General principles of cost allocation There are several general principles or guidelines of joint cost alloca- tion that underlie the rationale of the separable costs-remaining benefits method. In general, no project purpose should be assigned a cost that is in excess of the value of its benefit nor be supported by the benefit of another purpose. Thus, the charge for irrigation water should not be greater than the contribution of that water to the benefit of the project. Similarly, in general we feel that no purpose should be subsidized by another purpose. Power users in most cases should not be charged high rates to make irrigation water available at low cost to farmers. All the cost incurred for one purpose only should be allocated wholly to that purpose. The cost of canals is wholly allocated to the irrigation purpose, and the cost of the transmission lines wholly to the power purpose. Each "separable cost" is the minimum that can be charged for the respective purpcise. If the cost of the canals alone exceeds the benefit from the irrigation water, then clearly the project should not include an irrigation component. No purpose, however, should be assigned a cost that is any greater than would be incurred if that function were to be supplied by the most economic alternative single-purpose project. The alternative single- purpose project establishes the maximum that can be charged for any one purpose. It is not equitable to allocate to the power component of a 234 FINANCIAL ASPECTS OF PROJECT ANALYSIS multipurpose water development project a cost more than that of the alternative thermal plant that could provide the same electrical service, nor is it equitable to charge the irrigation component more than the cost of an alternative single-purpose pumping scheme. Separable costs-remaining benefits method The application of the separable costs-remaining benefits method is illustrated by the Senegal River Development Program cost allocation in table 6-5. The three West African states of Mali, Mauritania, and Senegal have formed the Senegal River Development Organization (known by the initials of its French name, oMvs) to plan and develop a multipurpose project on the Senegal River. In the configuration for which the joint cost allocation is outlined as an example, the project would consist of the multipurpose Manantali Dam on the Bafing River, a major tributary of the Senegal River, to provide a regulated flow; the Diama Dam close to the mouth of the river to prevent upstream intrusion of salty ocean water; a power generation station with associated distribution network at the Manantali Dam; and navigation improvements to permit year- round service to Mali. The benefits of the project are (1) increased produc- tion of agricultural crops because of double cropping in the dry season and better water regulation in the wet season, (2) power, and (3) reduced transport costs because of the navigation improvements. [This example is adapted from Riley and others (1978).] We will follow the analysis line by line. The first part of table 6-5 summarizes the basic information about the project that will be needed to allocate cost. The technical information would be supplied by the engineers and the other technicians; the cost and benefit would be esti- mated by the technical staff working with the economists. We begin with the project cost to be allocated (line 1.1). This is the total cost for the project as a whole that is to be allocated among the three purposes. Included are both the construction cost (line 1.1.1), stated at its present worth as of the beginning of the project, and the annual operation and maintenance cost (often abbreviated in project accounts as o&M; line 1.1.2) necessary to operate the project. The annual project benefit for each purpose is listed and the total of these is entered (line 1.2). In the Senegal River case, the power benefit was assumed to be the amount for which the power could be sold. In most instances, however, the power benefit would be assumed to be the annual cost of providing the same amount of electricity by means of the most economic single-purpose alternative project-always assuming that consumers would purchase electricity at that price. This simplification avoids the problems associated with valuing electricity. It implies that the real benefit of power-whatever that might be-is greater than the cost of the single-purpose alternative. The effect of this assumption is to set the maximum that can be charged for power to equal the benefit of the most economic alternative single-purpose project, which is what the analytical technique would do in any case. EFFECTS ON GOVERNMENT BUDGEF 235 Next is listed the alternative cost for each purpose (line 1.3), both for construction, stated at its present worth (line 1.3.1), and for the annual operation and maintenance charge (line 1.3.2). As noted, an alternative cost is the cost of the most economic single-purpose project that could provide one of the same benefits provided by the multipurpose project. An alternative does not have to be located at the multipurpose site, but it should be capable of producing its benefit in essentially the same geo- graphic area as the one in which the benefit from the multipurpose project is to be utilized. The alternative project may be of an entirely different physical nature, as would be the case if the alternatives to a multipurpose river development were pump irrigation and a thermal generating plant. Of course, the most economic single-purpose alterna- tive might cost more than the benefit it would generate; even the most economic alternative might not be justified as a separate project. Next is the separable cost (line 1.4) given by purpose, both for construc- tion at present worth (line 1.4.1) and for the annual operation and maintenance charge (line 1.4.2). Separable cost is expenditure that could be avoided if one purpose were excluded from the project. It is possible to find that no portion of the joint cost is solely and clearly traceable to a particular purpose. In measuring the separable cost, each purpose should be treated as if it were the last increment added to a project that serves all the other multiple purposes; in this way favoring one purpose over another may be avoided. In many projects, the annual figures such as those for the operation and maintenance cost and annual benefit in the Senegal River example would not be constant during the life of the project. In these instances, the present worth of the cost or benefit stream would be substituted because that is what is called for in the joint cost allocation in the second part of table 6-5. Indeed, Riley and his colleagues (1978) do treat both operation and maintenance cost and annual benefit in this manner in the report from which this example is drawn. The discount rate (line 1.5) is either the financing cost of the project if the project is to be constructed using loan funds or the government borrowing rate if the project is to be financed from allocations in the current government budget. The project life (line 1.6) and the length of the construction period (line 1.7) are part of the technical data supplied by those responsible for designing the project. Carrying out the analysis for a very long period, however, has little meaning because of the very small present worth of values assumed in the distant future. In the Senegal River project, for example, the physical facilities would probably last much longer than the thirty-year period chosen for analysis, but extending the period of analysis would hardly affect the joint cost allocation. The last part of tabulating the basic information for the joint cost allocation is to derive the factors for converting between annual values and present worth. The factor to convert annual cost or benefit to present worth (the present worth of an annuity factor; line 1.8) is computed for the discount rate as indicated. (The method of deriving the present worth 236 FINANCIAL ASPECTS OF PROJECT ANALYSIS of an annuity factor for a period beginning in the future is discussed in chapter 9, under "The Time Value of Money. Present worth of a stream of future income.") The factor to convert present worth of cost or benefit to annual cost (capital recovery factor) for a period beginning some time in the future (line 1.9) cannot be computed directly from the capital recov- ery factors given in standard tables in a manner similar to the computa- tion of the present worth of an annuity factor. This problem may be avoided, however, by taking advantage of the fact that the capital recov- ery factor for any period is the reciprocal of the present worth of an annuity factor for that period. Thus, we find that the capital recovery factor for the tenth through the thirtieth year at 10 percent is 0.272 636 (I - 3.667 890 = 0.272 636). Table 6-5. Joint Cost Allocation, Senegal River Development Program, West Africa (millions of CFAF) Purpose Iniga- Naviga- Line and item lion Power lion Total 1. Basic infornation 1 1. Project cost to be allocated 1.1.1 Construction (at present worth) 41,464 1.1.2 Annual O&M" 449 1 2. Annual project benefit 25,707 14,035 21,820 61,652 1.3. Alternative cost 1 3 1 Construction (at present worth) 16,120 5,233 23,980 45,333 1 3.2 Annual o&M 152 3,060 223 3,435 1 4 Separable cost 1.4.1 Construction (at present worth) 5,494 5,424 7,867 18,785 14 2 Annual o&M 55 109 75 239 1.5. Discount rate- 10 percent 1.6. Project life. 30 years 1.7. Construction period- 9 years 1.8 Factor to convert annual cost or benefit to present worth (present worth of an annuitN factor) Present worth of an annuity factor for 30 years at 10 percent 9.426 914 Less present worth of an annuity factor for 9 years at 10 percent -5,759 024 Present worth of an annuity factor for 10th through 30th years at 10 percent 3.667 890 1.9. Factor to convert present worth of cost of benefit to annual cost (capital recovery factor): Capital recovery factor Reciprocal for 10th through 30th years = of present 0.272 636 at 10 percent worth factor 3.667 890 2. Joint cost allocation (All values at present worth except distribution percentage) 2.1. Cost to be allocated 2.1.1 Construction (1.1.1) 41,464 2.1.2 o&M [(1 1.2) x 3.667 890] 1,647 Total [(2 1.1) + (2.1.2)1 43,111 2.2 Benefit [(1 2) x 3.667 8901 94,290 51,479 80,033 225,802 EFFECTS ON GOVERNMENT BUDGET 237 Table 6-5 (continued) Purpose Irriga- Naviga- Line and item tion Power tion Total 2.3. Alternative cost 2.3.1 Construction (1.3.1) 16,120 5,233 23,980 45,333 2.3.2 o&m [(1.3.2) x 3.667 890] 558 11,224 818 12,600 Total [(2.3.1) + (2.3 2)] 16,678 16,457 24,798 57,933 2.4. Justifiable expenditure [lesser of (2.2) or (2.3)] 16,678 16,457 24,798 57,933 2.5. Separable cost 2.5.1 Construction (1.4.1) 5,494 5,424 7,867 18,785 2.5.2 o&m [(1.4.2) x 3.667 890] 202 400 275 877 Total [(2.5.1) + (2.5.2)] 5,696 5,824 8,142 19,662 2.6. Remaining justifiable expenditure [(2.4) - (2.5)] 10,982 10,633 16,656 38,271 2.7. Percentage distribution of (2.6) 28.70 27.78 43.52 100.00 2.8. Remaining joint cost [total from lines indicated allocated according to (2.7)] 2.8.1 Remaining construction cost [(2.1.1) - (2.5.1)] 6,509 6,300 9,870 22,679 2.8.2 Remaining o&M [(2.1.2) - (2.5.2)] 221 214 335 770 Total [(2.8.1) + (2.8.2)] 6,730 6,514 10,205 23,449 2.9. Total allocated cost 2.9.1 Construction cost [(2.5.1) + (2.8.1)] 12,003 11,724 17,737 41,464 2.9.2 o&M [(2.5.2) + (2.8.2)] 423 614 610 1,647 Total [(2.9.1) + (2.9.2)] 12,426 12,338 18,347 43,111 3. Annual costs 3.1. Annual cost 3.1.1 Construction [(2.9.1) x 0.272 636] 3,272 3,196 4,836 11,304b 3.1.2 o&M [(2.9.2) x 0.272 636] 115 167 166 448" Total [(3.1.1) + (3.1.2)] 3,387b 3363b 5,002 1 1,752b CFAF African Financial Community francs. Source: Adapted from Riley and others (1978). a. o&M Operation and maintenance cost. b. The annual cost does not exactly equal the allocated cost times the capital recovery factor because of rounding. The second part of table 6-5 lays out the computation of the joint cost allocation. Note that all values (except the distribution percentages) are stated in their present worth equivalents. The cost to be allocated (line 2.1) is the total cost of the project, obtained by adding the construction cost at present worth (line 2.1.1), taken from line 1.1.1, and the present worth of the operation and maintenance cost for the project (line 2.1.2), computed by taking the value of CFAF449 million supplied in line 1.1.2 and multiplying it by the present worth of an annuity factor for the tenth through the thirtieth years, which gives CFAFl,647 million (449 x 3.667 890 = 1,647). (The symbol for African 238 FINANCIAL ASPECTS OF PROJECT ANALYSIS Financial Community francs is CFAF.) It is this cost that is to be allocated among the various purposes. The benefit (line 2.2) is the annual project benefit given in line 1.2 multiplied by the present worth of an annuity factor for the tenth through the thirtieth years. Thus, the present worth of the irrigation benefit stream over the life of the project is CFAF94,290 million (25,707 x 3.667 890 = 94,290). The alternative cost (line 2.3) lists the total costs for the most economic alternative single-purpose projects with the same benefit as the appropriate components of the multipurpose project. The subentries that are added for the total are taken from the first part of the table: the alternative construction cost (line 2.3.1) is given in line 1.3.1; the opera- tion and maintenance cost for the alternative single-purpose projects (line 2.3.2) is taken from the annual operation and maintenance cost in line 1.3.2 and is converted to present worth using the present worth of an annuity factor. The justifiable expenditure for each purpose (line 2.4) is either the bene- fit on line 2.2 or the total alternative cost on line 2.3, whichever is less. The sum of the justifiable expenditure for the various purposes is the total justifiable expenditure for the multipurpose project; this amount is entered in the total column of line 2.4. We noted this earlier: the amount to be allocated to a particular purpose is limited on the one hand by the benefit it will produce and on the other hand by the cost of the most economic single-purpose alternative. The separable cost (line 2.5) is taken from the first part of the table. The separable construction cost for each purpose (line 2.5.1) comes from line 1.4.1. The present worth of the separable annual operation and mainte- nance cost (line 2.5.2) is derived by multiplying the value in line 1.4.2 by the present worth of an annuity factor. The separable cost is then totaled. In general, the total separable cost for each purpose will be the minimum allocation that will be charged to that purpose. To determine the remaining justifiable expenditure (line 2.6) for each purpose and for the project as a whole, the separable cost of each purpose given in line 2.5 is deducted from the justifiable expenditure given in line 2.4. In the case of the irrigation purpose, for example, the separable cost of CFAF5,696 million is subtracted from the justifiable expenditure of CFAFl6,678 million, and this leaves a remaining justifiable expenditure of CFAFl0,982 million (16,678 - 5,696 = 10,982). Of course, if the value for any purpose is negative, it means that the present worth of the benefit at the discount rate being used is less than the present worth of the cost. If one purpose is not to subsidize another, then any purpose with a negative justifiable expenditure should be omitted from the project. The percentage distribution of the remaining justifiable expenditure in line 2.6 is calculated and entered in line 2.7. Now we must calculate the remaining joint cost for each purpose (line 2.8). This is done by allocating the joint cost of the project to each purpose in proportion to the excess over the separable cost that we would be justified in spending to realize the benefit from each purpose. We EFFECTS ON GOVERNMENT BUDGET 239 begin by determining the total remaining (joint) construction cost in the last column of line 2.8.1. To do this, the total separable construction cost for the entire project in the last column of line 2.5.1 is subtracted from the total construction cost for the entire project in line 2.1.1 to give the total remaining joint construction cost of CFAF22,679 million, which then is entered in the last column of line 2.8.1 (41,464 - 18,785 = 22,679). Similarly, the total remaining (joint) operation and maintenance cost in the last column of line 2.8.2 is determined by subtracting the separable operation and maintenance cost in line 2.5.2 from the total operation and maintenance cost in line 2.1.2. This gives a value of CFAF770 (1,647 - 877 = 770). These totals are then allocated to the various purposes according to the percentage distribution of the remaining justifiable expenditure in line 2.7. Thus, the remaining construction cost for irrigation is 28.70 percent of CFAF22,679, or CFAF6,509 (22,679 x 0.2870 = 6,509), and the remaining operation and maintenance cost for power is 27.78 percent of CFAF770, or CFAF214 (770 x 0.2778 = 214). The total of the remaining joint cost for each purpose is the sum of the remaining joint cost for construction (line 2.8.1) and operation and maintenance cost (line 2.8.2). The total allocated cost (line 2.9) may now be determined. The total allocated construction cost (line 2.9.1) for each purpose is determined by adding the separable construction cost for that purpose in line 2.5.1 to the remaining joint construction cost in line 2.8.1. Thus, the total allo- cated construction cost for the irrigation component is CFAF12,003 mil- lion (5,494 + 6,509 = 12,003). Similarly, the total allocated operation and maintenance cost for each purpose (line 2.9.2) is the sum of the separable operation and maintenance cost for that purpose in line 2.5.2 and the remaining joint operation and maintenance cost in line 2.8.2. Hence, the total allocated operation and maintenance cost for the irrigation purpose is CFAF423 million (202 + 221 = 423). The sum of the total allocated construction cost for each purpose and the total allocated operation and maintenance cost for each purpose is the total allocated cost for each purpose. Of course, the total allocated cost in the last column of line 2.9 must equal the total cost to be allocated in the last column of line 2.1, and this provides an internal check on the calculations. The third part of table 6-5 gives the annual costs. The annual cost (line 3.1) for each purpose is determined by multiplying the total allo- cated cost in line 2.9 by the capital recovery factor for the tenth through the thirtieth year at 10 percent as computed in the first part of the table. Thus, the annual cost for navigation is determined by multiplying the total allocated cost by the capital recovery factor to obtain the annual cost of CFAF5,002 million (18,347 x 0.272 636 = 5,002). Because of rounding, the annual costs for irrigation and power do not quite check when calculated in this manner. In table 6-5 the total annual cost (line 3.1) is shown as the total of the annual construction and annual operation and maintenance costs. The annual construction cost (line 3.1.1) and the annual operation and maintenance cost (line 3.1.2) may be determined separately as explained above. Thus, the annual construc- tion cost for irrigation is CFAF3,272 million (12,003 x 0.272 636 = 240 FINANCIAL ASPECTS OF PROJECT ANALYSIS 3,272), and the annual operation and maintenance cost chargeable to irrigation is CFAFll5 million (423 x 0.272 636 = 115). An equitable annual charge for the use of irrigation water in the project would thus be CFAF3,387 million, of which CFAF3,272 million would go toward the construction cost and CFAFl 15 million would be for operation and maintenance cost (3,272 + 115 = 3,387). If it were determined that the governments were to bear the capital cost of irrigation and the farmers to pay only the operation and maintenance cost, the farmers would have to pay only the CFAFl 15 million annual operation and maintenance charge. (In the Senegal River project, there would be additional cost to bring the water from the river to the fields, but this falls outside the project cost as such.) Note that the separable costs-remaining benefits method when calcu- lated using market prices only specifies what would be an equitable financial charge using as a sole criterion the cost incurred for each purpose and the benefit generated by each purpose. What the bene- ficiaries actually will be charged depends on many other considerations, as noted in the previous section on cost recovery. Sometimes, for exam- ple, the capital cost for irrigation will be assumed by the treasury and be paid from general tax revenues, but farmers will be assessed enough to pay for the operation and maintenance cost. Other services may also not be charged precisely the amounts the separable costs-remaining benefits method indicates as equitable. Often, for example, no charge is levied for flood control benefits that are paid for from the general revenue, and it is likely that power users will be charged the prevailing rate for the area served by the multipurpose project and not the rate determined by the annual cost of the project power component. We have covered the primary elements of joint cost allocation in this discussion. Readers who wish to go further might consult the report prepared by Riley and his group (1978) from which the Senegal River example is drawn; the report includes variations on the allocation method outlined here as well as interesting discussions of valuing benefit and allocating cost equitably between countries. A more extensive dis- cussion of joint cost allocation will be found in James and Lee (1970), and Loughlin (1977) proposes a modification of the separable costs-remain- ing benefits methodology to increase the equity by applying weights for the relative amounts of the separable cost assigned to each purpose. PART THREE Economic Aspects of Project Analysis ーグ響・又、hージー－末－---,．・・、がィと・：：メヤ戸’嘆一．．・讐 7 Determining Economic Values ONCE FINANCIAL PRICES for costs and benefits have been determined and entered in the project accounts, the analyst estimates the economic value of a proposed project to the nation as a whole. The financial prices are the starting point for the economic analysis; they are adjusted as needed to reflect the value to the society as a whole of both the inputs and outputs of the project. When the market price of any good or service is changed to make it more closely represent the opportunity cost (the value of a good or service in its next best alternative use) to the society, the new value assigned becomes the "shadow price" (sometimes referred to as an "accounting price"). In the strictest sense, a shadow price is any price that is not a market price, but the term usually also carries the connotation that it is an estimate of the economic value of the good or service in question, perhaps weighted to reflect income distribution and savings objectives. In chapter 2, for purposes of project analysis, we took the objective of a farm to be to maximize the farm family's incremental net benefit, the objective of the firm to maximize its incremental net income, and the objective of the society to maximize the contribution a project makes to the national income-the value of all final goods and services produced in the country during a particular period. These objectives, and the Facing page: Examining a farmer's poultry during an extension visit in Nigeria. 243 244 ECONOMIC ASPECTS OF PROJECT ANALYSIS analysis to test their realization, were seen in financial terms for farms and firms. But economic analysis of a project moves beyond financial accounting. Strictly speaking, we may say that in financial analysis our numeraire-the common yardstick of account-is the real income change of the entity being analyzed valued in domestic market prices and in general expressed in domestic currency. But in economic analysis, since market prices do not always reflect scarcity values, our numeraire becomes the real, net national income change valued in opportunity cost. As we will note below, one methodology expresses these economic values in domestic currency and uses a shadow price of foreign exchange; the shadow price increases the value of traded goods to allow for the pre- mium on foreign exchange arising from distortions caused by trade policies. Another method in use expresses the opportunity cost value of real national income change in domestic currency converted from for- eign exchange at the official exchange rate and applies a conversion factor to the opportunity cost or value in use of nontraded goods ex- pressed in domestic currency; the conversion factor reduces the value of nontraded goods relative to traded goods to allow for the foreign ex- change premium. Before a detailed discussion of adjusting financial accounts to reflect economic values commences, an important practical consideration must be emphasized. Many of the adjustments to the financial accounts can become quite complex. Not every point made in this chapter will apply to every agricultural project, nor will all points have the same importance in those projects where they do apply. The complexity of some calcula- tions and the relative importance of some adjustments recall the reason for undertaking an economic analysis of a project: to improve the invest- ment decision. Some adjustments will make a considerable difference to the economic attractiveness of a proposed project; others will be of minor importance, and no reasonable adjustment would change the investment decision. What we need to do here is to adopt an accounting practice- the doctrine of materiality. The analyst must focus his attention on those adjustments to the financial accounts that are likely to make a difference in the project investment decision. He should use rough approximations or ignore trivial adjustments that will not make any difference in the decision. There is an important balance to be struck between analytical elegance and getting on with the job. In this chapter we will adjust the financial prices of tangible items to reflect economic values in three successive steps: (1) adjustment for direct transfer payments, (2) adjustment for price distortions in traded items, and (3) adjustment for price distortions in nontraded items. Before embarking on this series of adjustments, we will examine the problem of determining the appropriate premium for foreign exchange. After com- pleting the adjustments, we will summarize the main points in a "deci- sion tree" for determining economic values. The series of successive adjustments to the financial accounts will lead to a set of economic accounts in which all values are stated in "efficiency prices," that is, in prices that reflect real resource use or consumption DETERMINING ECONOMIC VALUES 245 satisfaction and that are adjusted to eliminate direct and indirect trans- fers. These values will be market prices when market prices are good estimates of economic value or they will be shadow prices when market prices have had to be adjusted for distortions. When we adjust financial prices to reflect economic values better, in the vast majority of cases we will use the opportunity cost of the good or service as the criterion. We will use opportunity costs to value all inputs and outputs that are in- termediate products used in the production of some other good or ser- vice. For some final goods and services, however, the concept of oppor- tunity cost is not applicable because it is consumption value that sets the economic value, not value in some alternative use. In these instances, we will adopt the criterion of "willingness to pay" (also called "value in use"). We need to do this, however, only when the good or service in question is nontraded (perhaps as a result of government regulation) during some part of the life of the project-a point to which we will return later in our discussion. Because the ultimate objective of all economic activity is to satisfy consumption wants, all opportunity costs are derived from consumption values, and thus from willingness to pay. An example may clarify our use of willingness to pay and opportunity cost. Suppose a country that is a rather inefficient producer of sugar has a policy to forbid sugar imports to protect its local industry. The price of sugar may then rise well above what it would be if sugar were imported. Even at these higher prices, most consumers will still buy some sugar for direct consumption-say, in coffee or tea-even though they may use less sugar than if the price were lower. The domestic price of sugar will be above the world market price and will represent the value of the sugar by the criterion of willingness to pay. If we were now to consider the economic value of sugar from the standpoint of its use in making fruit preserves, its value would become the opportunity cost of diverting the sugar from direct consumption, where willingness to pay is the criterion and has set the economic value. Economic analysis, then, will state the cost and benefit to the society of the proposed project investment either in opportunity cost or in values determined by the willingness to pay. The costs or values will be deter- mined in part by both the resource constraints and the policy constraints faced by the project. The difference between the benefit and the cost-the incremental net benefit stream-will be an accurate reflection of the project's income-generating capacity-that is, its net contribution to real national income. The system outlined here will make no adjustment for the income distribution effects of a proposed project nor for its effect on the amount of the benefit generated that will be invested to accelerate future growth. Rather, the economic project analysis, stated in efficiency prices, will judge the capacity of the project to generate national income. The analyst can then choose from those alternative projects (or alternative formulations of roughly the same project) the high-yielding alternative that in his subjective judgment also makes the most effective contribu- tion to objectives other than maximizing national income-objectives 246 ECONOMIC ASPECTS OF PROJECT ANALYSIS such as income distribution, savings generated, number of jobs pro- duced, regional development, national security, or whatever. The choice about the kind of project will of course be made rather early in the project cycle. Thus, it may be determined early on that for reasons of social policy a project will be preferred that encourages smallholder agricul- ture rather than plantations. Then, the choices will likely be several projects or variants of projects that encourage smallholders; the analyti- cal technique presented here can determine from among the projects that will further the desired social objective the ones that are more economically efficient. Although the system outlined here makes no adjustment for income distribution effects or for saving versus consumption, it is compatible with other analytical systems that do. In particular, Squire and van der Tak (1975) recommend evaluating proposed projects first by using essen- tially the same efficiency prices that will be estimated here and then by further adjusting these prices to weight them for income distribution effects and for potential effects on further investment of the benefits generated. The systems in Little and Mirrlees (1974) and the UNIDo Guide- lines for Project Evaluation (1972a), with minor departures, also propose evaluating the project by first establishing its economic accounts in efficiency prices and then by adjusting these accounts to weight them for income distribution and savings effects. Making allowances for income distribution and savings effects involves somewhat more complex adjustments than those necessary to estimate efficiency prices; it also unavoidably incorporates some element of subjective judgment. Although these systems have attracted widespread interest among econ- omists, their application has been only partial or on a limited scale. The system of economic analysis using efficiency prices that is outlined here is essentially the one currently used for all but a few World Bank projects and also the one used for most analyses of projects funded by other international organizations. The economic analysis follows on the financial analysis presented in the preceding chapters; it will be based on projected farm budgets simi- lar to those in chapter 4, on projected accounts for commercial firms such as those in chapter 5, and on projected government cash flows such as those in chapter 6. Since these accounts are projected for the life of the project, there will be no separate allowance for depreciation. Instead, as noted earlier, the costs will have been entered in the years they are incurred and the returns in the year they are realized. In the economic analysis, we will want to work with accounts cast on a constant basis; thus we will want to be sure that any inflation contin- gency allowances have been taken out. As noted in chapter 2, however, physical contingency allowances and contingency allowances intended to allow for relative price changes are properly incorporated in the eco- nomic accounts, even when the accounts are in constant prices. Of course, any of the items included among the contingencies may be re- valued, if necessary, to adjust them from their market prices to economic values. The projected financial accounts will usually not have any entry DETERMINING ECONOMIC VALUES 247 for cash. Instead, they will show separately the cash position of the farmer or note a cumulative cash surplus or deficit. It is possible, how- ever, that some accounts may have a cash balance included in an entry for working capital or the like. If such an entry exists, it must be removed from the economic analysis; since we will be working on a real basis in the economic accounts, we will show real costs when they occur and real benefits when they are realized. Determining the Premium on Foreign Exchange Adjusting the financial accounts of a project to reflect economic values involves determining the proper premium to attach to foreign exchange. That determination quickly involves issues of obtaining proper values and of economic theory. Fortunately for most agricultural project analysts, the answer to the question about how to determine the foreign exchange premium is simple (and simplistic): ask the central planning agency. The point is that if various alternative investment opportunities open to a nation are to be compared, the same foreign exchange premium must be used in the economic analysis of each alternative. Otherwise we will be mixing apples and oranges and cannot use our analysis reliably to choose among alternatives. Sometimes, however, the analyst will be forced to make his own estimate of the foreign exchange premium. A practical approach, along with some of the theoretical and applied prob- lems of the computation, is given by Ward (1976). Little and Mirrlees (1974), Squire and van der Tak (1975), and the UNIDo Guidelines (1972a) also outline in considerable detail how to make the conversion between foreign exchange and domestic currency when their analytical systems are used. The need to determine the foreign exchange premium arises because in many countries, as a result of national trade policies (including tariffs on imported goods and subsidies on exports), people pay a premium on traded goods over what they pay for nontraded goods. This premium is not adequately reflected when the prices of traded goods are converted to the domestic currency equivalent at the official exchange rate. The pre- mium represents the additional amount that users of traded goods, on an average and throughout the economy, are willing to pay to obtain one more unit of traded goods. Since all costs and benefits in economic analysis are valued on the basis of opportunity cost or willingness to pay, it is the relation between willingness to pay for traded as opposed to nontraded goods that establishes their relative value. The premium people are willing to pay for traded goods, then, repre- sents the amount that, on the average, traded goods are mispriced in relation to nontraded items when the official exchange rate is used to convert foreign exchange prices into domestic values. By applying the premium to traded goods, we are able to compare the values of traded and nontraded goods by the criterion of opportunity cost or willingness to pay. Although this premium is commonly referred to as the foreign 248 ECONOMIC ASPECTS OF PROJECT ANALYSIS exchange premium, it should be recognized that the premium is actually a premium for traded goods; foreign exchange itself has no intrinsic value. The premium for traded goods is a premium on the particular "basket" of traded goods that the present and projected trade pattern implies. Of course, future patterns of trade could change the exact com- position of the basket, and thus the premium would change; to estimate these changes involves a knowledge of elasticities-the way demand and supply of goods and services vary when prices change-that is generally not available. Where such elasticities are known, it is possible for a well-trained economist to provide the project analyst with a more accu- rate estimate of the expected premium on foreign exchange. If traded items were to be taken into the project analysis at an eco- nomic value obtained by simply multiplying the border price by the official exchange rate without adjusting for the foreign exchange pre- mium, imported items would appear too cheap and domestic items too dear. This would encourage overinvestment in projects that use imports. For example, if combine harvesters look cheap because no allowance is made for the premium on traded goods, then imported combines might displace local harvest labor, even though the local labor might have no other opportunities for employment. There are two equivalent ways of incorporating the premium on for- eign exchange in our economic analysis. The first is to multiply the official exchange rate by the foreign exchange premium, which yields a shadow foreign exchange rate. [Note that this derivation of the shadow exchange rate is appropriate for efficiency analysis of projects and thus has a discrete definition. Other definitions of the shadow exchange rate are appropriate depending on the uses to which the rate will be put. Bacha and Taylor (1972) discuss some of these alternatives.] The shadow exchange rate is then used to convert the foreign exchange price of traded items into domestic currency. The effect of using the shadow exchange rate is to make traded items relatively more expensive in domestic currency by the amount of the foreign exchange premium. (An alterna- tive arithmetic formulation is to convert the foreign exchange price into domestic currency at the official exchange rate and then multiply by 1 plus the foreign exchange premium stated in decimal terms.) The sha- dow exchange rate approach has been used in the past in most World Bank projects when adjustments have been made to allow for the foreign exchange premium on traded goods, and it is also used in the UNIDO Guidelines (1972a). An alternative way to allow for the foreign exchange premium on traded items that is increasingly coming into use is to reduce the domes- tic currency values for nontraded items by an amount sufficient to reflect the premium. This is sometimes called the "conversion factor" approach. In its simplest form, based on straightforward efficiency prices, a single conversion factor-the "standard conversion factor" of Squire and van der Tak-is derived by taking the ratio of the value of all exports and imports at border prices to their value at domestic prices (Squire and van der Tak 1975, p. 93). In this form, the standard conver- DETERMINING ECONOMIC VALUES 249 sion factor bears a close relation to our shadow exchange rate; indeed, the standard conversion factor may be determined by dividing the of- ficial exchange rate by the shadow exchange rate or by taking the recip- rocal of 1 plus the foreign exchange premium stated in decimal terms. Market prices or shadow prices of nontraded items are then multiplied by this standard conversion factor, and this reduces them to their appropriate economic value. Little and Mirrlees and Squire and van der Tak both adopt the conversion factor approach. In addition, both pairs of authors recommend deriving specific conversion factors for particular groups of products that will allow for any difference between market prices and opportunity costs and for the foreign exchange premium on traded items. As a result, their specific conversion factors may always be applied directly to domestic market prices. These authors also recom- mend that their conversion factors be calculated in social prices by including distribution weights. In the valuation system followed here, all items are valued at efficiency prices without allowance for distribution weights (the issue of selecting projects to achieve distributional objectives is treated as a subsequent decision). This being the case, consideration of the distribution-weighted conversion factors proposed by Little and Mirrlees and Squire and van der Tak may be left aside, and we may focus our discussion on the Squire and van der Tak standard conversion factor as it relates to efficiency prices. The relation between the official exchange rate (in the equations be- low, OER), the foreign exchange premium (Fx premium), the shadow exchange rate (SER), and the standard conversion factor (scF) is perhaps easier to understand in equation form: OER X (1 + Fx premium) = SER and, =s, (1 + Fx premium) so that, as Squire and van der Tak note (1975, p. 93), OER OER SER = OER and ScF = _ SCF SER We may illustrate these relations by an example taken from the Agri- cultural Minimum Package Project in Ethiopia. At the time the project was appraised, the analyst knew that the official exchange rate of Eth$2.07 = US$1 failed to account for a foreign exchange premium of at least 10 percent. (The symbol for the Ethiopian dollar is Eth$; since this project was appraised the name of the currency unit has been changed to birr.) Thus, the analyst multiplied the official exchange rate by I plus a 10 percent foreign exchange premium to obtain a shadow exchange rate of Eth$2.28 = US$1 (2.07 x 1.1 = 2.28) that he rounded up to Eth$2.30 = US$1. The shadow exchange rate was then applied to all traded items in the financial accounts, thereby increasing their relative value. If the domestic currency is worth more per unit than the foreign exchange, the arithmetic is somewhat different. At the time the Nucleus 250 ECONOMIC ASPECTS OF PROJECT ANALYSIS Estate/Smallholder Oil Palm Project in Rivers State, Nigeria, was appraised, the official exchange rate was NI = US$1.54. (The symbol for Nigerian naira is N.) The project analysts were given a shadow exchange rate of NI = US$1.27 to use in their economic evaluation. If, however, they had simply been informed that the foreign exchange premium was 21 percent, they could have determined the shadow exchange rate by dividing the dollar value by 1 plus the premium stated in decimal terms (1.54 + 1.21 = 1.27). Of course, the effect of applying the shadow exchange rate to the traded items in the Ethiopian project was to make all nontraded items 10 percent less expensive in relation to the traded items in the economic accounts as opposed to the financial accounts. Now, instead of increasing the relative value of traded items, we could reduce the value of all nontraded items appearing in the financial accounts so that in the eco- nomic account they are relatively 10 percent less expensive. To do this we calculate the standard conversion factor, which is 1 divided by 1 plus the amount of the foreign exchange premium stated in decimal terms. In this case, the result is a factor of 0.909 (1 - 1.1 = 0.909). To obtain the economic values, we would then multiply all financial prices for non- traded items by this factor if these market prices have been judged good estimates of opportunity cost or good estimates of economic value on grounds of willingness to pay. For nontraded items such as wage rates for unskilled labor for which it is felt that the market price has overstated the economic values, we would first determine a good estimate of the eco- nomic value in domestic currency and then multiply that by the standard conversion factor. Financial prices for traded items, whether imports or exports, would be left unchanged in the economic accounts except that any transfer payment included in these prices would be taken out. To get all values into the same currency, we would convert all foreign currency prices to domestic currency values using the official exchange rate. When we turn to determining measures of project worth in chapter 9, we will find that the absolute value of the net present worth differs depending on which approach we use, shadow exchange rate or conver- sion factor, but that the relative net present worths of different projects analyzed by the same approach will not change. Whichever approach is used, the internal rate of return, the benefit-cost ratio, and the net ben- efit-investment ratio do not change. (Using a number of disaggregated conversion factors, rather than a standard conversion factor, can give different values for the measures of project worth. Hence, for projects at the margin of acceptability, using specific conversion factors rather than a standard conversion factor or a shadow exchange rate may result in a different decision on whether to accept or reject, but such cases are infrequent.) Adjusting Financial Prices to Economic Values Let us now proceed with the adjustments necessary to convert finan- cial prices to economic values. We will divide these into three steps: (1) DETERMINING ECONOMIC VALUES 251 adjustment for direct transfer payments, (2) adjustment for price distor- tions in traded items, and (3) adjustment for price distortions in non- traded items. We will then note that, for what are termed "indirectly traded" items (locally produced items that use a high proportion of traded inputs, such as locally assembled tractors, or construction that uses imported materials), steps 2 and 3 must be done at the same time. Step 1. Adjustment for direct transfer payments The first step in adjusting financial prices to economic values is to eliminate direct transfer payments. Direct transfer payments (see chapter 2) are payments that represent not the use of real resources but only the transfer of claims to real resources from one person in the society to another. In agricultural projects, the most common transfer payments are taxes, direct subsidies, and credit transactions that include loans, receipts, repayment of prin- cipal, and interest payments. Two credit transactions that might escape notice are accounts payable and accounts receivable. All these entries should be taken out before the financial accounts are adjusted to reflect economic values. Many important subsidies in agriculture operate not by means of direct payments but through mechanisms that change market prices. These subsidies are not direct subsidies treated as direct transfer pay- ments but rather are indirect subsidies. The financial price of an item for which the price has been changed because of an indirect subsidy is converted to an economic value according to the procedures outlined below for traded items in step 2 and, as appropriate, for nontraded items in step 3. Step 2. Adjustment for price distortions in traded items The second step in adjusting financial prices to economic values is the adjustment for distortions in market prices of traded items. Traded items are those for which, if exports, f.o.b. price > domestic cost of production, or the items may be exported through government intervention by use of export subsidies and the like, and, if imports, domestic cost of production > c.i.f. price. Conceptually-and usually in practice, too-prices for traded items in project analysis are more easily dealt with than those for nontraded items. We begin the valuation by determining the "border price." For imports, this normally will be the c.i.f. price and, for exports, normally the f.o.b. price. The border price is then adjusted to allow for domestic transport and marketing costs between the point of import or export and the project site; the result is the efficiency price to be used in the project account (see the subsection on "Economic export and import parity values," below). 252 ECONOMIC ASPECTS OF PROJFCT ANALYSIS If the proposed project produces something that can be used in place of imported goods-that is, if it produces an "import substitute"-the value to the society is the foreign exchange saved by using the domestic product valued at the border price, in this case the c.i.f. price. But if the project uses items that might otherwise have been exported-that is, if it uses "diverted exports"-then the opportunity cost to the society of these items is the foreign exchange lost on the exports forgone valued at the border price, this time the f.o.b. price. If we are using conversion factors to allow for the foreign exchange premium, the economic value of a traded item would be obtained by converting the foreign exchange price to its domestic currency equiva- lent using the official exchange rate. If we are using the shadow exchange rate to allow for the foreign exchange premium, the economic value of a traded item would be obtained by converting the foreign exchange price to its domestic cur- rency equivalent using the shadow exchange rate. To illustrate how these computations are made, we may take as an example an imported item such as a combine harvester for which the c.i.f. price is US$45,000. In the financial accounts, we will convert this price to domestic currency using the official exchange rate of, say, RslO = US$1, obtaining a c.i.f. price in domestic currency of Rs450,000 (45,000 x 10 = 450,000). To this would be added any import duty, say 10 percent, or Rs45,000 (450,000 x 0.10 = 45,000); the price of the combine in our financial accounts would therefore be Rs495,000 (450,000 + 45,000 = 495,000). (The costs of moving the harvester to the project site would also be added; see the subsection on "Economic export and import parity values," below.) If we are using the conversion factor approach to allow for the foreign exchange premium in our economic accounts, we would enter the combine in the accounts at the c.i.f. price expressed in domestic currency converted at the official exchange rate, or Rs450,000 (45,000 x 10 = 450,000). There would be no allowance for the duty because that is a transfer payment. If we are using the shadow exchange rate approach to allow for the foreign exchange premium, however, we would increase the price of the imported items to reflect the premium. Suppose we assume the foreign exchange premium to be 20 percent; our shadow exchange rate thus becomes Rsl2 = US$1 (10 x 1.2 = 12). Now the Rs495,000 item in our financial accounts becomes Rs540,000 in our economic account (45,000 x 12 = 540,000). We could have accomplished the same thing, of course, by multiplying our domestic financial price (net of transfer payments) by I plus the foreign exchange premium (450,000 x 1.2 = 540,000). The effect of our computation, obviously, is to make imported items more expensive in our economic analysis. The same logic works in reverse for exports. The ton of wheat that is worth $176 a ton f.o.b. at the port of export wil I be entered in the financial accounts by converting the foreign exchange price to its domestic cur- rency equivalent using the official exchange rate. This gives a value of Rs1,760 (176 x 10 = 1,760), assuming that there is no export subsidy. The same rupee value would be entered in the economic accounts if we DETERMINING ECONOMIC VALUES 253 are using the conversion factor approach to allow for the foreign ex- change premium. If we are using the shadow exchange rate approach to allow for the foreign exchange premium, we multiply the foreign ex- change border price of the wheat by the shadow exchange rate instead of the official exchange rate to calculate the economic value expressed in domestic currency. This increases the relative value of the wheat, which now will be valued at Rs2,112 (176 x 12 = 2,112). We could have accomplished the same thing, of course, by multiplying our financial domestic price by 1 plus the foreign exchange premium stated in decimal terms (1,760 x 1.2 = 2,112). Now the ton of wheat, like other exported goods, is valued at its opportunity cost and is seen to be relatively much more valuable. Diverted exports and import substitutes are valued by the same line of reasoning, except that for a diverted export we would take the f.o.b. price as the basis for valuation and for import substitutes we would take the c.i.f. price. In the examples of the previous paragraphs, if the country exported combines but diverted them to a domestic project, the oppor- tunity cost would be based on the f.o.b. price instead of the c.i.f. price we assumed for imported combines. Similarly, if the wheat produced were to substitute for imports, we would base its value on the c.i.f. price of wheat rather than on the f.o.b. price we assumed for the case of exports. In practice, values for most traded items are determined by taking the border price as we have been using it and then either subtracting or adding the domestic handling costs to obtain an economic value at the farm gate or project boundary-the economic export or import parity value (see the subsection on "Economic export and import parity values," below). Also, many items that are locally produced incorporate a significant proportion of imported components and may be considered indirectly imported items (see the section on "Indirectly Traded Items," below). To determine either parity values or values for indirectly traded items involves valuing separately not only the traded component but the nontraded component as well, so we will defer detailed discussion of these values until we have discussed valuing nontraded items. Step 3. Adjustment for price distortions in nontraded items The third step in adjusting financial prices to economic values is the adjustment for distortions in market prices of nontraded items. Nontraded items are those for which c.i.f. price > domestic cost of production > f.o.b. price, or the items are nontraded because of government intervention by means of import bans, quotas, and the like. Often, nontraded items will be bulky goods such as straw or bricks, which by their very nature tend to be cheaper to produce domestically than to import but for which the export price is lower than the domestic cost of production. In other instances, nontraded items are highly perish- able goods such as fresh vegetables or fluid milk for direct consumption. 254 ECONOMIC ASPECTS OF PROJECT ANALYSIS In general, these are produced under relatively competitive conditions- they are produced either by many small farmers or by a few industrial producers for whom entry into the market is relatively easy; thus prices cannot rise too far out of line before new competition appears. If we are using the shadow exchange rate approach to allow for the foreign exchange premium, and if the market price of a nontraded item is a good estimate of the opportunity cost, or willingness to pay is the criterion, we will accept the market price directly as our economic value. Otherwise, we will adjust the market price to eliminate distortions by the methods outlined in this section and then use the estimate of the oppor- tunity cost we obtain as the shadow price to be entered in the economic accounts. If we are using the conversion factor approach to allow for the foreign exchange premium, an additional step is necessary. All prices for non- traded items are reduced by multiplying them by the appropriate con- version factor. When willingness to pay is the criterion or when the market price is considered to be a good estimate of opportunity cost, the market price is accepted as the basis for valuation and then reduced by multiplying it by the conversion factor to obtain the economic value. But if we are using the standard conversion factor and the market price must be adjusted to obtain a better estimate of the opportunity cost, then the opportunity cost must, in turn, be multiplied by the standard conversion factor. (If specific conversion factors have been developed, as Little and Mirrlees and Squire and van der Tak suggest in their systems, then these factors incorporate the adjustments for nontraded goods distortions, opportunity costs, and distribution weights; the market price need only be multiplied by the specific conversion factor to reach the economic value.) Whether we use a shadow exchange rate or a standard conversion factor to allow for the foreign exchange premium, the adjustments we make to allow for distortions in market prices of nontraded items are essentially the same; only the step of multiplying the market price or the opportunity cost by the standard conversion factor differs. As we said earlier in the chapter, prices for traded items are more easily adjusted to economic values than are prices for nontraded items. The following subsections treat some of the difficulties encountered in deter- mining economic values for various nontraded items. MARKET PRICES AS ESTIMATES OF ECONOMIC VALUE. In a perfectly competi- tive market, the opportunity cost of an item would be its price, and this price would also be equal to the marginal value product of the item (see chapter 3). If a nontraded item is bought and sold in a relatively competi- tive market, the market price is the measure of the willingness to pay and is generally the best estimate of an opportunity cost. Most agricultural projects are expected to meet a growing demand for food or fiber and are small relative to the total agricultural production of the nation. If that is the case, in general we can accept the market price directly as our estimate of the economic value of a nontraded item. Also, if we are valuing a domestically produced project input that is produced by a DETERMINING ECONOMIC VALUES 255 supply industry operating near full capacity, we can generally accept the market price of the input as its economic value. In some instances more common in industrial and transport projects than in agricultural, the output of the project is large relative to the market. The output from the project may therefore cause the price to fall. But the economic value of the new production, despite the fall in price, is not lower to the old users of the product; to them, it is still worth what the price was without the project. Yet to new users, the project output is not worth what the old price was; otherwise, the price would not have fallen. Under these circumstances, the economic value of the new output is neither the old price nor the new; rather, it is estimated by some weighted average of the old and new values. In technical economic terms, the total value of the new output is measured by the additional area under the demand curve as project output is increased, and the marginal value in use for each new buyer is measured by the demand curve at the point the buyer enters the market. The problem is that the precise shape of the demand curve is rarely known. As a result most project economists, when dealing with a project whose output is large relative to the market, adopt a simplifying rule of thumb-they assume that the demand curve is linear and downward sloping at 45 degrees. They then take the new estimate of the average value in use or opportunity cost-hence, of economic value-to be the average of the price without the project and the lower price with the project. Sometimes a project will be proposed that does not meet new demand but replaces other goods or services in the market. Again, this is more common in industrial and transport projects than it is in agricultural. In such situations, if the project accounts are cast on a with-and-without basis, the economic value of the incremental net benefit stream would reflect only the saving from the new project compared with the old. This is because one of the costs of the new project would be the benefit forgone from the old production no longer realized and because one of the ben- efits would be the cost avoided for the old production. Such a case might arise, for instance, if an inefficient food processing plant were to be replaced by a more modern and efficient one, or if a high-cost railway branch line were to be replaced by bus and truck transport along an existing highway. Occasionally, however, a project will be proposed for a new plant that will replace existing output, and the analyst fails to recognize the with-and-without situation. Instead, he values the output from the new plant as if it were meeting new demand and forgets to charge as a cost to the project the benefit forgone from the production of the old plant that is to be displaced. If the project is not to be cast on a with-and-without basis, then the analyst must take as his gross benefit only the economic value of the resources saved by replacing the old plant, not the economic value of the output from the new plant. Note that some nontraded items may involve using significant amounts of imported raw materials. These will be considered below, in the discussion of indirectly traded items. Such items might include machinery assembled domestically from imported components or elec- 256 ECONOMIC ASPECTS OF PROJECT ANALYSIS tricity that is generally nontraded but that may require imported gener- ating equipment and traded fuels for production. One nontraded item that can sometimes lead to confusion is insurance. At first glance, insurance might look like a transfer payment and thus would not be included in the economic accounts of the project. We may, however, look upon insurance as a kind of sharing of the risk of real economic loss. This would be the case for fire insurance if project build- ings were to be pooled with many other buildings in the society. In the event of a fire, there is a real economic cost. The resources used to replace a burned building, or the output forgone because a building no longer is available, reduce the amount of final goods and services available to the society and thus create a real reduction of the national income. There- fore, to the extent an insurance cost represents sharing of risk, it repre- sents a proportionate sharing of real economic cost and should be in- cluded in the economic accounts. The insurance rate is usually based on the probability of a real loss and the value of the item insured. Although the market price can frequently be accepted as a good esti- mate of the economic value of a nontraded item, for institutional reasons of one kind or another the market price can vary significantly from the opportunity cost of the item to the society. Two such nontraded items are important in most agricultural projects: land and labor. VALUING LAND. The opportunity cost of land is the net value of produc- tion forgone when the use of the land is changed from its without-project use to its with-project use. The simplest case to value is one in which land changes use but not management control, either because an owner-operator is farming the land or because the same tenant continues to farm it. This is a common case in agricultural projects in which farmers are simply encouraged to adopt a more productive technology. If the analyst has laid out the financial accounts to show the situations with and without the project for farm budgets as suggested in chapter 4, then the incremental net benefit (that is, the incremental cash flow) of the project, when financial prices have been converted to economic values and the accounts aggregated as suggested in chapter 8, will include an allowance for the net value of production forgone by changing the land use. Take, for example, the Kemubu Irrigation Project in Malaysia in which new irrigation water permitted changing the land use in the dry season from rather unproduc- tive pasture to second-crop paddy rice production. The contribution of the land to the value of the pasture-hence, its opportunity cost-would be properly accounted for when the value of the weight gain of the livestock pastured on the land without the project is subtracted from the value of the paddy rice produced on the land with the project. Converting project financial prices to economic values-say, changing the market price of the weight gain of the animals on the pasture and the market price of paddy rice to their economic equivalents if these arc seen to be different from the market prices-automatically revalues the opportun- ity cost of the change in land use from financial to economic terms. DETERMINING ECONOMIC VALUES 257 In other instances, however, the financial accounts must show a cost for purchasing land or the right to use it. Here problems arise because in many countries agricultural land is hardly sold at all, and, when it is, considerations of investment security and prestige may push its price well above what the land could reasonably be expected to contribute to agricultural production. In these instances, we will not want to accept the market purchase price as a good estimate of the economic opportun- ity cost of the land and must search for an alternative. Many times that alternative will be to take the rental value of the land. In a number of countries, although land is infrequently sold, there is a fairly widespread and competitive rental market. This may be true if there is considerable tenancy in the country, of course, but it may also hold true if the domi- nant form of land tenure is the owner-occupied farm. Older farmers may not wish to cultivate all of their holdings themselves and will be willing to rent a field to a younger neighboring farmer; widows may not wish to operate their holdings themselves; or a farmer suffering from an illness may wish to rent part of his farm for a season while he recovers. When such a rental market exists, it probably provides a fairly good indication of the net value of production of the land and, hence, of the opportunity cost if the land use is changed. A renter is not likely to pay any premium for prestige or investment security and thus will not pay a rent higher than the contribution the land can make to the crop he proposes to grow. That rental value may then be entered in the project's financial account year by year as a cost. Alternatively, it may be capitalized by dividing the rent by an appropriate rate of interest stated in decimal terms; the capitalized value is then entered in the first year of the project's financial accounts. The appropriate rate of interest actually would be the eco- nomic rate of return (see chapter 9), but this may well involve repetitive computations. Some analysts prefer to use the opportunity cost of capital (also discussed in chapter 9). If this rate were, say, 12 percent and the going rental rate were Rs525 a hectare, then the capital value of a hectare would be Rs4,375 (525 + 0.12 = 4,375). If we were using the conversion factor approach to allow for the foreign exchange premium, this capital- ized value would be, in turn, multiplied by a conversion factor. If the standard conversion factor were 0.909, for instance, the land would then have an economic value of Rs3,977 (4,375 x 0.909 = 3,977). At the end of the project, the same value of the land could be credited to the project as a residual value. Inevitably, however, there will be instances in which neither the purchase price nor the rental value is a good estimate; we then will have to make a direct estimate of the productive capability of the land. Such a direct estimate is not difficult if idle land is to be used for a settlement project. In the projects financed by the World Bank in the Amazon basin at Alto Bene in Brazil and in the Caqueta region of Colombia, the land without the project would in effect have produced no economically valuable output at all. Hence, the net value of production forgone was clearly zero, and no value for the land was entered in the project eco- nomic accounts. If settlers were required to pay the government a pur- 258 ECONOMIC ASPECTS OF PROJECT ANALYSIS chase price, either all at once or in installments, the farm budgets at market prices in the financial analysis would have to show those pay- ments as a cost. When these financial farm budgets were converted to economic values, however, there would be no cost entered for the land because there was no reduction in national income as a result of shifting its use from jungle to farmland. (Of course, the cost of clearing jungle land should be reflected somewhere in the project costs.) In other cases it will not be so simple. The analyst will have to make a direct estimate of the net value of production forgone for bringing the land into the project. A straightforward approach is to take the gross value of the land's output at market prices and deduct from that all the costs of production-including allowances for hired and family labor and for the interest on the capital engaged, again all at market prices. The analyst can assign the residual as the contribution of the land to the production of the output and take that as the opportunity cost of the land in financial terms. This set of computations can then be converted to economic terms by using economic values for each of the input and output entries. For those familiar with the technique, estimating a pro- duction function would provide a much more accurate estimate of the contribution of the land to the value of the output than the direct method described here and thus is a preferable approach. VALUING LABOR. Wage rates for labor in many developing countries may not accurately reflect the opportunity cost of shifting labor from its without-project occupation to its with-project use. The price of labor in a perfectly competitive market, like other prices in that impossible place, would be determined by its marginal value prod- uct. That is, the wage would be equal to the value of the additional product that one additional laborer could produce. It would pay a farmer to hire an additional laborer-for harvesting, for example-so long as that extra worker increased total output by a value more than the wage the farmer had to pay him. Even in labor-abundant societies, there are probably peak seasons at planting and harvesting when most rural workers can find employment. At those seasons, the market wage paid rural labor is probably a pretty good estimate of its opportunity cost and its marginal value product; therefore, we could accept the market wage as the economic value of the rural labor. The problem of course is that, except for the peak seasons, in many crowded countries the addition of one more laborer may add very little to the total production-in an extreme instance, nothing at all. That is, if there is a surplus of agricultural workers, there may be very little or virtually no productive outlet for their energies in the off-season. In technical language, we may say that the marginal value product of such labor-the amount such labor adds to the national income-is very close to zero. Because the marginal value product of labor is also the opportun- ity cost of labor in the economic accounts, we may make another state- ment: if we take a laborer away from a farm community where he is DETERMINING ECONOMIC VALUES 259 producing very little or nothing and put him to work productively in an agricultural project that produces something of value, we do not have to forgo very much to use this labor to realize new production. This being the case, we can consider the cost of the laborer to be very low-some economists would say even zero. By this line of reasoning, the proper value to enter in the economic (not financial) account as the cost of labor would be very small, perhaps only a fraction of the going market wage. If the opportunity cost of labor in an agricultural project is properly priced at a very small amount, then it is likely that the rate of return on the project will look very favorable in comparison, say, with a capital- intensive alternative project that uses labor-saving tractors or expensive imported harvesting machinery. Note that the validity of this reasoning is not changed by the fact that agricultural labor is, in fact, paid a wage well above its opportunity cost. A common example of a "wage" paid, even though little productive work is available on the margin, is found in the case of family labor. Older children and the farmer's wife will be entitled to a share of the family income even if the family farm is too small to give them an opportunity to be productive. In this instance, if an older son were to find productive employment elsewhere, the total production on the farm might be re- duced by very little or none at all. Yet, because the older son is entitled to a share of the total family income, he would accept new employment far away from his home only if he were offered a wage in excess of his share-and that might be well above what his marginal value product would be and the reduction in farm output that would occur if he were to leave. Rural wages may be above the marginal value product because of a traditional concept of a "proper" wage or because of social pressure on the more prosperous farmers in a community to share their wealth with their less fortunate neighbors. In parts of Java, for example, social cus- tom prevents even quite small farmers from harvesting their own rice. Instead, they permit landless laborers to do the work, even though the farmer himself may well have the time to do it. This is explicitly seen by the community as a means of providing at least something for the poorest agricultural laborers. Unfortunately, increasing economic pressures on small farmers and continued population growth are leading to a break- down of this system. Virtually all economists now agree that the marginal value product of agricultural labor on an annual basis worldwide is more than zero, so that in every instance our opportunity cost of labor, at least in some season or another, will be positive-even though it may still be very low. [A more detailed discussion of the marginal value product of agricultural labor can be found in McDiarmid (1977) and in Barnum and Squire (1979).] To begin our discussion of how actually to determine an economic value for labor, we can take the easiest case. In most instances, skilled labor in developing countries is considered to be in rather short supply and would most likely be fully employed even without the project being 260 ECONOMIC ASPECTS Of PROJECT ANALYSIS considered. Hence, the wages paid workers such as mechanics, foremen, or project managers are in general assumed to represent the true mar- ginal value product of these workers, and the wages are entered at their market values in the economic accounts. The rationale here is that, if those skills are in such scarce supply that they would be worth more than the going wage, then someone in the society would be prepared to pay more, and the skilled worker would then move to where he could earn that higher wage, thus establishing a new equilibrium. This convention of accepting market wages as good estimates of economic value may substantially undervalue skilled labor or the management skills of such top civil servants as extension specialists and project managers-or project analysts! Note too that, as we consider the opportunity cost of labor and how to estimate it, if we set the financial accounts so they correctly show the situations with and without the project, then the opportunity cost of family labor will be appropriately priced in financial terms. Suppose that, in the dry season without the project, a farmer along the north coast of Java could find essentially no gainful employment. With the advent of the Jatiluhur Irrigation Project he now is able to produce a second crop of rice, and his net benefit rises accordingly. When we subtract his without- project net benefit (which would be essentially only what the family could earn for a rainy-season rice crop) from the with-project net benefit (which will include earnings from two crops), the incremental net benefit will correctly show the labor return the family had to give up during the dry season (essentially nothing) to participate in the project and produce a second crop of rice. Shifting the financial prices in the farm budget to economic values also automatically converts the opportunity cost of family labor to economic values. To make our farm budgets work this way, we must remember to include any off-farm earnings in the accounts. Suppose we assume that the farmer from the north coast of Java goes to Jakarta and finds employ- ment in the construction industry during the dry season, as many such farmers do. The without-project net benefit will thus be increased by the amount of the farmer's off-farm earnings. If he wishes to use Jatiluhur irrigation water to produce a second crop of rice, he must now give up the construction wages he could otherwise have earned in the dry season. In turn, when we subtract the without-project net benefit from the with- project net benefit, which includes the returns from two crops of rice, the incremental net benefit will be smaller by the amount of the opportunity cost of labor at the market wage, that is, by the amount of construction earnings the farmer must forgo. We may proceed to convert these finan- cial accounts to economic terms by revaluing the appropriate entries at their shadow prices. In doing so, however, we must remember that one shadow price will be the shadow wage rate for the construction earnings the farmer had to forgo. It is to estimating this shadow wage rate that we now may turn. In most discussions of the marginal value product of labor-hence, of its economic opportunity cost-the standard is the productivity of the marginal agricultural laborer. This is true not only for agricultural DETERMINING ECONOMIC VALUES 261 projects but also for projects in other sectors, since it is assumed that additional manufacturing employment, for example, will tend to reduce the number of unemployed agricultural laborers. This would be true even if it is urban workers drawn from some other urban occupation who actually take the new factory jobs, since it is assumed the jobs they vacate will, in turn, be filled by workers drawn from agriculture. Cast in this form, our estimate of the shadow wage rate must now focus on how to estimate the marginal value product of agricultural labor without the project. We can begin by noting that in most agricultural communities there is usually a season when virtually everyone who wants work can find it. Even unemployed urban laborers may return to their home villages in these peak seasons to help their families or to work as hired laborers. This happens at harvest time in Java, and may happen at the peak planting time in other areas where transplanted rice is grown. Thus, we may reasonably assume that this peak season labor market is a relatively competitive one, that labor is in relatively short supply at this period, and that the daily wage at this period is a good indicator of the daily marginal value product of the labor engaged. With this accepted, a good estimate of the annual shadow wage for agricultural labor is the number of days in the year when most rural labor can expect to find employment, multiplied by the daily wage rate at such times, and reduced by a conversion factor if appropriate. If an agricultural worker's daily wage at harvest were Rs7.50, and during harvest and other peak seasons most people in the rural work force could find employment for 90 days, then his annual shadow wage might be Rs675 if we are using the shadow exchange rate approach to allow for the foreign exchange premium (7.50 x 90 = 675), or Rs614 if we are using the conversion factor approach and the factor is 0.909 (7.50 x 90 x 0.909 = 614). Now if we wanted to hire an agricultural laborer to work in our project for 250 days a year, all the society would give up in production- the opportunity cost-would be Rs675 if we are using the shadow ex- change rate approach, or Rs614 if we are using the conversion factor approach. This opportunity cost is the economic value of the annual earnings of the laborer without the project. Note that we surely would have to expect to pay a wage much greater than this amount, and thus our financial accounts at market prices would have quite a different cost for this same agricultural laborer. It is possible, for instance, that the hired laborer would expect a wage of Rs7.50 a day for all 250 days he worked during the year, or an annual wage of Rsl,875 (7.50 x 250 - 1,875). More probably, he would be willing to work for rather less a day outside the harvest season-say, Rs5.00 a day. Thus, his annual wage might be something more on the order of Rs675 for 90 days and Rs5.00 a day for the remaining 160 days, or an annual total wage of Rs1,475 [(7.50 x 90) + (5.00 x 160) = 1,475]. The project analyst would clearly have to form a judgment of the shadow wage of hired labor on the best basis he could, just as he must for every other price estimate he makes. Of course, in many agricultural projects labor is not engaged on a year-round basis. Rather, the work is quite seasonal, and we must con- sider in which particular season hired labor would be engaged. If our new 262 ECONOMIC ASPECTS OF PROJECT ANALYSIS cropping pattern calls for work to be done during the peak season, then we will have to consider that the peak season market wage is probably a good estimate of the marginal value product, and we could not justify using a lower wage as the basis for our shadow wage rate, even though there might be considerable unemployment in the off-season. In Egypt, for example, a common rotation calls for both rice and cotton to be harvested in October. If we were to propose a project incorporating these crops--or another crop requiring hired labor at this period-then the going wage (in 1975 about E£O.30 a day; the symbol for Egyptian pounds is Ef) would be paid. Since even in a country as populous as Egypt most rural labor can find employment at this peak season, the use of a shadow wage rate derived from a basis less than the market wage would be unjustified. But suppose our project called for growing maize, which is planted in May when there is little other agricultural work available and harvested in August before the peak harvest season for rice and cotton. Then we might find that, on the margin, many agricultural laborers were either unemployed or not very productively engaged at that season and that to draw them into maize planting might entail an opportunity cost considerably less than the going wage, although it would perhaps not be zero. Thus, we might estimate that at this season the combination of being able to work only two or three days a week on the average, and then at jobs of rather low productivity, would justify taking a shadow wage rate based on half the going market rate. This would mean the equivalent of EE0.15 in 1975 if we are using the shadow foreign exchange rate approach (0.30 + 2 = 0.15), or EE0.14 if we are using the conversion factor approach and the conversion factor is 0.909 (0.30 + 2 x 0.909 = 0.14), even though our farm budget at market prices would continue to show a wage for hired labor of E£0.30. All of these considerations will have to be adapted to fit the circum- stances of any given project. For example, in India nationwide we might expect a shadow wage rate for agricultural labor rather less than the going wage rate. But using a nationwide shadow wage rate in particular projects might underestimate the true opportunity cost of the labor actually engaged in a project. The peak season in the Punjab, for instance, finds virtually all agricultural labor fully engaged, but in the neighboring state of Haryana the marginal labor in agriculture is not fully engaged. While many laborers from Haryana do migrate in search of peak season employment in the Punjab, not enough do so to meet the demand for labor completely. Using a very low shadow wage rate for a project in the Punjab might be unjustified because at the peak season the project would have to bid labor away from harvesting. Thus, although the shadow wage rate might not be as high as the harvest wage (but it might), neither would it be as low as conditions in neighboring Haryana might otherwise indicate. This discussion of how to value labor applies whether labor is to be paid a money wage or is to be compensated in kind. The discussion so far has emphasized that it is the opportunity cost that determines the value of labor in the system of economic analysis we have adopted. The value of DETERMINING ECONOMIC VALUES 263 the payment actually made to labor-whether in money or in kind-is not the issue. If we shadow-price labor, we already are acknowledging that the wage the labor receives is different from the benefit forgone by using that labor in the project instead of in its next best alternative use without the project. It is the opportunity cost of the labor, not the form of payment, that sets the economic value of labor. Hence, it is irrelevant in a determination of the economic value of labor whether labor is paid a money wage or is compensated in kind-for example, in food grain, even though the food grain may be a tradable commodity and even though the food grain itself might need to be shadow-priced if it is to be valued. EXCESS CAPACITY. In some projects, a domestically produced input may come from a plant that is not operating at its full capacity. If that is the case, then the opportunity cost of using the input in a new project is only the marginal variable cost of producing the input, and no allowance need be made for the fixed capital cost of the plant itself. If the national cement industry is operating at less than its full capacity and it is proposed to line irrigation canals with cement, then the cost of the cement for the canals would be only the marginal variable cost of producing the cement. This would be less than the average cost of cement production, which would include some allowance for fixed costs of production. Situations such as these are more common in industrial projects than in agricultural projects. When they do occur, however, they may in- fluence the timing of projects. A canal-lining project might be quite attractive if it is begun soon, while there is excess cement-manufacturing capacity, but much less attractive later, when demand has caught up with the cement industry's capacity. To supply cement for canal lining later, after demand has picked up, would entail constructing an addi- tional cement plant. At that time, new fixed as well as variable costs would be incurred, and the analyst would include all costs, both fixed and variable, plus an estimate of the "normal" profit in calculating the cost of cement. TRADABLE BUT NONTRADED ITEMS. In the system of project analysis pre- sented here, we lay out the economic accounts as best we can to reflect the real resource costs and benefits of the proposed project. The project will be carried out within a framework of economic policies set by the government. The project analyst must make the best judgment about what those policies are and will be, not just what they ought to be, and work the economic analysis accordingly. This can lead to difficult choices when the analyst must evaluate the real effects on resources of a project that involves items that could be traded but probably will not be because of government regulation. These items, which are "tradable but non- traded" across national boundaries, are valued as nontraded. Such items would usually be imported were it not for an import quota or an outright ban that is enforced against them. Their domestic price may well rise high above the prevailing price on the world market. The import restriction might be enforced to protect domestic industries, even 264 ECONOMIC ASPECTS OF PROJECT ANALYSIS though the imported item may be preferred by consumers. Import of foreign engines for tubewells, for example, may be forbidden so that domestic manufacture might be encouraged. Yet, the domestic equiva- lent may not be as efficient or as durable as the imported engine and may cost more to produce. The domestic engine clearly could not compete on the world market, and it would therefore be a nontraded item. For those few imported engines allowed to enter the country, the price may rise quite high. This indicates that to some buyer the imported item is worth more than its domestic equivalent. If our project will use one of these engines, the economic value is not a price based on the world market as if the engines could be relatively freely traded. Rather, it is the higher domestic market price of the imported engine, which indicates its high opportunity cost. Upon reexamination, of course, we might consider changing the project design to use the domestic engine-for example, we might do so if we find the domestic engine to be less costly when valued at shadow prices. For the domestic equivalent of an imported item, the market price usually will closely approximate the real resource use that went into producing it. But if there is a shortage and the price is bid up, in the absence of additional imports the market price will rise above the cost of production. In this case, the opportunity cost of the item will not be determined by the resources used to produce it but by its marginal value product in its best alternative use. If the price is higher than is justified by the resources used to produce the item, it may well be because to someone that high price for the domestic engine is worth it-for this buyer's purposes, the marginal value product of the scarce engine at least equals the market price. If we wish to bid that engine away for use in our project, we are denying its use to the other potential buyer. If we use the engine in our project, the economy must forgo the productive contribution of the engine in the alternative use the other potential buyer had in mind-our standard concept of opportunity cost. Again, in this instance the oppor- tunity cost is most likely well estimated by the market price; if it were not, other buyers would not have bid the price up so high for the limited number of engines available. If there is an import ban on an imported final good or service, then we will base the economic valuation on the criterion of willingness to pay and accept the market price as a good indicator of the economic value of the product-provided that we expect the trade ban to remain in force throughout the life of the project. Earlier we cited the example of a ban on sugar imports that would force the domestic price of sugar above its border price. If the ban on imports will continue, then the higher price of sugar indicates a willingness to pay that, in turn, is an indicator of the economic value set on sugar by the consumers. In the project analysis, we would accept this market price as the economic value, not a border price as if the sugar were being traded. For both kinds of import substitutes we have cited, the analyst may want to prepare an analysis that will indicate the effect on the proposed project of lifting the import ban. We will discuss this topic further below, DETERMINING ECONOMIC VALUES 265 in the section on using economic analysis to signal alternative trade policies. Note that, when we refer to items that are nontraded because of government regulation, we are really referring to those items that are nontraded on the margin. In other words, if there is a rigidly enforced quota on an imported item that restricts imports well below the quantity that otherwise would be imported, and if our project represents an additional demand for the imported item, then the item must be consid- ered nontraded for the purpose of our project analysis. It is not only imports that may be nontraded items because of govern- ment regulation, although imports are probably the most common ex- amples. Export bans may drive the price of a product below what the price would be if the product were traded. Several years ago, egg produc- ers in Pakistan had developed a brisk trade with the Persian Gulf states, and Pakistani egg production was expanding to fill the demand. Produc- tion could not, however, expand fast enough to prevent domestic egg prices from rising. Egg prices were, in fact, reflecting the world market price. To protect lower-income urban consumers, the government im- posed an export ban on eggs. The domestic market was immediately oversupplied, and the price fell well below the export price. The willing- ness to pay for the additional production was reflected in the low price. Domestic consumers were willing to purchase the additional eggs only if the prices were quite attractive. If we had been contemplating an egg production project at that time, and we judged that the government regulation forbidding export would continue in force, then the value of eggs taken for our analysis would have been the low domestic market price arising from the willingness to pay, not some price derived as if the eggs were traded. By valuing tradable but nontraded goods as nontraded, our system incorporates less of a free trade bias than if we assumed that all tradable items could and should be traded. Policies forbidding export or import of tradable items, however, will lead to a less than optimal allocation of resources in the economy, at least in the short run and, thus, to economic inefficiencies. We will return to this below when we discuss trade policy signals from project analysis. Indirectly traded items Some nontraded items in fact involve a substantial import content and are thus indirectly traded. When this is the case, it is good practice to value these items by valuing the domestic content as a nontraded item but the imported component as a traded item. Indirectly traded items in agricultural projects might be locally assembled tractors or construction that uses materials with a high import content. Indirectly traded items offer no conceptual problem. In the financial analysis, as usual we accept the actual market price. In the economic analysis, however, we must "decompose" the indirectly imported item into its imported component and its domestically produced component 266 ECONOMIC ASPECTS OF PROJECT ANALYSIS and value each separately. Take locally assembled tractors, for example. We may be told that the market price of Rs65,000 includes a 30 percent local component (in other words, 30 percent of the market price repre- sents domestic value added) and that 70 percent of the market price represents the imported component, which includes a 15 percent tariff. Thus, the local component will amount to Rsl9,500 (65,000 x 0.3 = 19,500), and the imported component including the tariff will amount to Rs45,500 (65,000 x 0.7 = 45,500). The domestic value added will most likely arise from sources such as wages paid domestic skilled labor and domestically manufactured items that use mainly domestic raw mate- rials. If so, we probably can accept the market price as a good indicator of the opportunity cost to the economy of these items. To determine the economic value of the imported component of the tractor, the tariff must first be eliminated. This may be done by dividing the value of the imported component including the tariff by 1 plus the percentage of the tariff stated in decimal terms; this calculation gives a value for the imported component without the tariff of Rs39,565 (45,500 + 1.15 = 39,565). This is, of course, the c.i.f. price converted to its domestic equivalent at the official exchange rate. Now, if we are using the shadow exchange rate to allow for the foreign exchange premium, we will want to revalue the imported component of the indirect import (after the tariff has been eliminated) to reflect the distortion in the prices of traded goods. To do this, we can take the c.i.f. price converted at the official exchange rate and multiply it by 1 plus the foreign exchange premium stated in decimal terms. If the official ex- change rate is RslO = US$1 and the foreign exchange premium is 20 percent, then for the imported component of the tractor we derive a value of Rs47,478 (39,565 x 1.2 = 47,478). (We could, of course, have taken the c.i.f. price in foreign exchange and converted it to its domestic equivalent by the shadow exchange rate; this would have given the identical result.) The shadow price of the tractor is now the market price of the domestic component, which we calculated to be Rsl9,500, plus the shadow-priced value of the imported component of Rs47,478-or a total economic value of Rs66,978 (19,500 + 47,478 = 66,978). If we are using the conversion factor to allow for the foreign exchange premium, the economic value of the imported component will be the c.i.f. price converted to the domestic currency equivalent at the official ex- change rate after eliminating the tariff, or Rs39,565. To obtain the eco- nomic value of the domestic component we will need to multiply it by the conversion factor. For efficiency prices, we would use the standard con- version factor of I divided by 1 plus the foreign exchange premium stated in decimal terms. In this instance, the foreign exchange premium is 20 percent, so the standard conversion factor becomes 0.833 (1 + 1.2 = 0.833). Applying this to the domestic component of the tractor, estimated to be Rsl9,500 at market prices, gives us an economic value of Rs]6,244 (19,500 x 0.833 = 16,244). The shadow price of the tractor now becomes the sum of the imported component valued at c.i.f. converted at the DETERMINING ECONOMIC VALUES 267 official exchange rate and the shadow price for the domestic component, or Rs55,809 (39,565 + 16,244) = 55,809). In some agricultural projects, electricity is an important cost that may raise valuation problems. Electricity is usually thought of as a nontraded commodity. In reality, part of the value of electricity in most developing countries arises from the imported generating and transmission equip- ment and, perhaps, from imported fuel. Thus, in our system of project analysis, electricity might be an indirectly traded item. The first diffi- culty is that the price charged for electricity is not competitively set, since there is no competition in electricity. Rather, electricity rates are administered prices, and electricity prices thus may bear little relation to marginal value product or to opportunity cost. No easy means exists to resolve this problem. Some average rate, or perhaps some weighted average rate, will probably have to suffice as an estimate of opportunity cost at market prices. Once a rate is accepted, an estimate will have to be made of the domestic and imported components, and the components revalued using the shadow exchange rate or a conversion factor as appropriate, just as for any other indirectly imported item (and as we illustrated earlier by the example of tractors assembled from imported components). These calculations would usually not be undertaken by agricultural project analysts. The planning office should estimate a sha- dow price for electricity and other utilities to be used in all project analyses. For some agricultural projects, new generating facilities will be re- quired. In the simplest case, we might think of a project remote from the electric grid, such as a settlement project, in which a diesel generating unit might be included as a cost of the project. In that instance, there would be no particular problem of valuation. When new generating facilities would be needed to meet the demand on the power grid arising from an irrigation project, however, the problem would not be so simple. Here, the best approach would probably be to ask the electricity author- ity for an estimate of the additional cost the authority would incur for this particular project, and then to treat that cost-properly shadow- priced to allow for the imported component-as the opportunity cost. The cost of the additional facilities needed for the project will probably have to be reduced to a kilowatt-hour basis (using, perhaps, the capital recovery factor to estimate the annual charge for the new facilities). We have contrasted use of a shadow exchange rate and a conversion factor to correct for price distortions caused by import and export tariffs and subsidies, and we have noted that the same correction can be real- ized whichever approach is used. This is illustrated in table 7-1, in which an economic account for a hypothetical project is drawn up using both a shadow exchange rate and a standard conversion factor. When indirectly traded items will be used repeatedly in projects, it may be convenient to have specific conversion factors that, once they are derived, can be directly applied to the same class of indirectly traded items. This is the approach both Little and Mirrlees (1974) and Squire Table 7-1. Use of Shadow Exchange Rate and Standard Conversion Factor Compared Economic value (Rs)b Using Using Financial valuea shadow standard exchange conversion Item Rs US$ rate' factord Remarks Inflow Gross value of wheat Traded item produced 1,750 175 2,100 1,750 Total 1,750 175 2,100 1,750 Outflow Unskilled labor Nontraded (shadow wage rate item = 50% market wage) 600 60 300 250 Imported fertilizer 200 20 240 200 Traded item Tractor services Indirectly 75% imported traded item component 9 9 108] 90 25% domestic 120 12 138 115 component 30 3 30 25 Total 920 92 678 565 Net benefit 830 83 1,422 1,185 Ratio of inflow to outflow 1.90 1.90 3.10 3.10 Rs Indian rupees. US$ U.S. dollars. are converted into domestic currency values by multiplying the foreign cur- a. The official exchange rate is assumed to be RsIO = US$1. Financial rency price by Rsl2 prices are converted by this official exchange rate. d. The standard conversion factor is the reciprocal of 1 plus the foreign b. The foreign exchange premium is assumed to be 20 percent As in note a, exchange premium stated in decimal terms, or 0.833 (1 - 1.2 = 0.833). the official exchange rate is assumed to be RslO = US$1. Foreign currency prices are converted into decimal currency values at the c. The shadow exchange rate is the official exchange rate of RsI0 multiplied official exchange rate. Domestic currency prices are multiplied by the stan- by I plus the percentage of the foreign exchange premium stated in decimal dard conversion factor of 0.833. terms, or Rs 12 (10 x 1.2 = 12), so that Rsl 2 = US$1. Foreign exchange prices DETERMINING ECONOMIC VALUES 269 and van der Tak (1975) suggest, and both sets of authors recommend that some central agency prepare specific conversion factors for project analysts to use. It is possible in a parallel manner to derive "specific shadow exchange rates" that may then be applied repeatedly, although in practice this has rarely been done. Instead, when the shadow exchange rate approach is followed, nontraded items are decomposed into their traded and nontraded elements and each is valued separately. Use of a specific conversion factor can be illustrated by referring to table 7-1. Suppose we planned a number of projects in which tractor services would be important and we wanted a specific conversion factor for tractor services. Once we had the conversion factor in hand, we could multiply the domestic market price of items in each project by the same specific conversion factor to obtain the various economic values. In table 7-1, in the column illustrating use of the standard conversion factor, we have a value for the imported component of the tractor services of Rs90, which was converted at the official exchange rate. The domestic compo- nent was multiplied by the standard conversion factor to obtain an economic value of Rs25. If we accept this as a good estimate of the value of the domestic component, then by adding the two we reach an eco- nomic value for the tractor services of Rsl 15. If we divide this economic value by the domestic price, we obtain a specific conversion factor of 0.958 (115 - 120 = 0.958). In the future, we can simply multiply the market price of tractor services by the specific conversion factor to obtain the economic value directly. Economic export and import parity values The economic value of a traded item-either an export or an import- at the farm gate or project boundary is its export or import parity value. These values are derived by adjusting the c.i.f. (cost, insurance, and freight) or f.o.b. (free-on-board) prices (converted to economic values) by all the relevant charges (again converted to economic values) between the farm gate or project boundary and the point where the c.i.f. or f.o.b. price is quoted. The general method of calculating export and import parity prices was discussed in the last section of chapter 3. When these financial prices are adjusted to derive their economic equivalent, both traded and nontraded elements must be valued simultaneously. The methods for deriving import and export parity values are parallel. Thus, it is unnecessary to discuss the method for both; instead, we will discuss only derivation of the import parity price as an example because import parity values tend to be a bit more complicated to derive. We may return to the example of the imported combine harvester used earlier in the chapter to illustrate economic valuation of a traded item. In our financial accounts, the c.i.f. price of US$45,000 was converted to its domestic currency equivalent at the official exchange rate of RsO = US$1, to which we would add, say, a 10 percent duty, Rsl,500 in domes- tic handling and marketing charges, and Rs2,250 in internal transport costs to the project site-for an import parity price at the farm 270 ECONOMIC ASPECTS OF PROJECT ANALYSIS gate of Rs498,750 [(45,000 x 10) + (45,000 x 10 x 0.10) + 1,500 + 2,250 = 498,750]. To obtain the economic import parity value at the farm gate or project boundary when using the shadow exchange rate to allow for the foreign exchange premium, we would make the same computations except that we would use the shadow exchange rate and omit the tariff, which is a transfer payment. In the illustration of valuing traded items, we assumed that the foreign exchange premium on the imported combine was 20 percent, and so we assumed a shadow exchange rate of Rsl2 = US$1 (10 x 1.2 = 12). Now, to obtain the import parity value of the harvester, we would convert the c.i.f. price to its domestic equivalent using the shadow exchange rate, omit the tariff, and then add the value of the nontraded domestic items. To simplify matters, we will assume that all costs of moving the combine to the project site reflect only nontraded items- although that might not be acceptable if, say, the transport costs in- cluded significant amounts of petroleum fuel. We now reach an economic import parity value of Rs543,750 [(45,000 x 12) + 1,500 + 2,250 = 543,750]. If we are using the conversion factor to allow for the foreign exchange premium, the foreign exchange would be converted to its domestic cur- rency equivalent in the economic accounts by using the official exchange rate, and every nontraded item would be reduced by the conversion factor. Recalling that the standard conversion factor is 1 divided by 1 plus the foreign exchange premium stated in decimal terms, we obtain a standard conversion factor of 0.833 (1 + 1.2 = 0.833). Now, to obtain the economic import parity value of the harvester at the farm gate or project boundary, we convert all foreign exchange costs to domestic currency at the official exchange rate and reduce all prices of nontraded items by applying the standard conversion factor. Again, we will assume that the transport costs are predominantly made up of nontraded items. As be- fore, we will omit the tariff because it is a transfer payment. The eco- nomic import parity price thus becomes Rs453,124 [(45,000 x 10) + (1,500 x 0.833) + (2,250 x 0.833) = 453,124]. In certain instances, the value in local currency of an imported item at the project site will be known, as will the rate of tariff and local transport charges from the point of import to the project site. If this is the case, to determine the economic value it is necessary to determine the c.i.f. price, take out the tariff, and allow for the cost of domestic transport. Using our previous values, we may know, for example, that a combine harvester delivered to the project site costs Rs498,750, that the tariff on imported harvesters is 10 percent, and that local transport and domestic handling from the point of import to the project site costs Rs3,750. We know that the official exchange rate is Rsl0 = US$1 and that the foreign exchange premium is 20 percent, so the shadow exchange rate would be Rsl2 = US$1 (10 x 1.2 = 12) and the standard conversion factor 0.833 (1 + 1.2 = 0.833). We deduct the cost of local transport to obtain a financial value of Rs495,000 at the point of entry, which includes the c.i.f. price plus the duty (498,750 - 3,750 = 495,000). To take out the duty, we divide by 1 plus the percentage of the duty stated in decimal terms to obtain DETERMINING ECONOMIC VALUES 271 Rs450,000 (495,000 + 1.1 = 450,000). This is the c.i.f. value at the official exchange rate. We can then divide by the official exchange rate to obtain the c.i.f. value in foreign exchange of US$45,000 (450,000 - 10 = 45,000). If we are using the shadow exchange rate to allow for the foreign ex- change premium, we can obtain our c.i.f. economic value by multiplying by the shadow exchange rate of Rsl2 = US$1 to obtain a value of Rs540,000 (45,000 x 12 = 540,000). Then, to obtain the economic value at the project site, we would add the cost of transport from the point of entry to the project site; this yields an economic import parity value for the harvester at the farm gate or project boundary of Rs543,750 (540,000 + 3,750 = 543,750). If we are using the conversion factor to allow for the foreign exchange premium, the economic value of the combine at the port will be the c.i.f. foreign exchange price converted at the official exchange rate, or Rs450,000 (45,000 x 10 = 450,000). To obtain the economic import parity value at the farm gate or project boundary, we would add to this c.i.f. value the cost of domestic transport and domestic handling, reduced by the standard conversion factor, to obtain an eco- nomic import parity value of Rs453,124 [450,000 + (3,750 x 0.833) = 453,124]. It is clear that to derive the import and export parity values in the economic analysis we must omit transfer payments, allow for the foreign exchange premium, and use shadow prices for those domestic goods and services for which prices are inaccurate indicators of opportunity cost. The same examples from the Sudanese and Nigerian projects used to illustrate the discussion of import and export parity prices in chapter 3 (tables 3-3 and 3-4) are used again in tables 7-2 and 7-3 to show economic parity values using both the shadow exchange rate and the conversion factor to allow for the foreign exchange premium. Trade Policy Signals from Project Analysis Up to this point, we have been discussing an analytical system that estimates the contribution of a proposed project to national income within a policy framework that the project analyst considers will exist during the life of the project. We have assumed that the project analyst has very little influence on trade policies, for this is true in the agriculture sector in most countries. Questions often arise, however, about the effects on a proposed project if trade policies were to change, and about whether changes in trade policies should be recommended. Unfortunately, when assessing the effects on a project of policies that would lift or impose a ban on trade, the analytical issues become very complex, and the analy- sis of a single project is of limited usefulness. The limitations of project analysis in influencing policy arise from the partial nature of project analysis and from the assumption that the project investment does not significantly change price relations in the economy as a whole. Two important cases involving trade policy often arise that cause soul-searching among project analysts. The first is when a quota or prohibitive tariff prevents entry of a crucial input-perhaps fertilizer- Table 7-2. Economic Export Parity Value of Cotton, Rahad Irrigation Project, Sudan (1980 forecast prices) Steps in the Relevant steps in Value per ton calculation the Sudanese example Lint Seed Scartoa Using shadow exchange rate C.i.f. at point of entry Ci.f. Liverpool taken as estimate for all European ports) US$639.33 US$103.39 - Deduct unloading at point of import Freight and Deduct freight to insurance - 39.63 - 24.73 - point of import Deduct insurance Equals f.o.b. at point of export F.o b Port Sudan US$599.70 US$78.66 - Convert foreign currency Converted at shadow to domestic currency exchange rate of at shadow exchange rate £Sdl.000 = US$2.61 1b ESd229.682 £Sd30 126 - Deduct local port Port handling cost charges Lint- £Sd5.564 per ton - 5.564 - Seed: £Sdl.510 per ton - 1.510 Deduct local transport Freight to Port Sudan and marketing at ESd6.782 per ton - 6.782 - 6.782 - costs from project to point of export (if not part of project cost) Equals export parity Export parity value value at project at gin at project boundary site £Sd217 336 £Sd21.834 - Conversion allowance Convert to seed cotton 86.934 12.882 1.102 if necessary (£Sd217.336 x 0.4 I I + £Sd21.834 x 0.59 £SdlO0.918 + £Sd110.200 x 0.01)< Deduct local storage, Ginning, baling, and transport, and storage (£Sdl5.229 marketing costs (if not per ton) - 15.229 part of project cost) Collection and internal transfer (£Sdl.064 per ton) - 1.064 Equals export parity Export parity value value at farm gate at farm gate £Sd84.625 Using conversion factors C.i.f. at point of entry C.i.f. Liverpool (taken as estimate for all European ports) US$639.33 US$103.39 - Deduct unloading at point of import Freight and Deduct freight to insurance - 39.63 - 24.73 - point of import Deduct insurance Equals f.o.b. at point of export F.o.b. Port Sudan US$599.70 US$78.66 - Convert foreign currency Converted at official to domestic currency exchange rate of at official exchange ESdl.000 = US$2.872b ESd208.809 ESd27.389 - rate (Table continues on the following pages.) Table 7-2 (continued) Steps in the Relevant steps in Value per ton calculation the Sudanese example Lint Seed Scartoa Convert nontraded goods Converted using to equivalent domestic standard conversion value using conversion factor of 0.909b factors Deduct local port Port handling cost charges Lint: £Sd5 564 per ton - 5.058 Seed- £Sdl.510 per ton - 1.373 Deduct local transport Freight to Port Sudan and marketing at £Sd6.782 per ton - 6.165 - 6.165 - costs from project to point of export (if not part of project cost) Equals export parity Export parity value value at project at gin at project boundary site £Sd197.586 £Sd19.851 - Conversion allowance Convert to seed cotton 79.034 11.712 1.002 if necessary (£Sdl97.586 x 0.4 + £Sd19.851 x 0.59 + £SdIl0.200 x 0.909 £Sd91.748 x 0.01)c Deduct local storage, Ginning, baling, and transport, and storage (£Sd15.229 marketing costs (if not per ton) - 13.843 part of project cost) Collection and internal transfer (£Sdl.064 per ton) - 0.967 Equals export parity Export parity value value at farm gate at farm gate £Sd76.938 £Sd Sudanese pounds. premium of 10 percent. Thus, the dollar value of the Sudanese pound at the Source: Adapted from World Bank, "Appraisal of the Rahad Irrigation official exchange rate of £SdI.000 = US$2.872 has been divided by 1.1 to give Project," PA-139b (Washington, D.C., 1973; restricted circulation), annex 16, an assumed shadow exchange rate of £Sd1.000 = US$2.611 (2.872 - 1.1 = table 6. The format of the table is adapted from William A. Ward, "Calculating 2.611), whereas the standard conversion factor is divided by 1 plus the foreign Import and Export Parity Prices," training material of the Economic Develop- exchange premium, or 0.909 (1 - 1.1 = 0.909). In the appraisal report that is ment Institute, CN-3 (Washington, D.C.: World Bank, 1977), p. 9. the source of this table, no foreign exchange premium was assumed. a. Scarto is a by-product of very short, soiled fibers not suitable for export c. Seed cotton is converted to lint, seed, and scarto assuming that a ton of and is sold locally at a price of £Sdl 10.200 per ton, seed cotton yields 400 kilograms lint, 590 kilograms seed, and 10 kilograms b. For purposes of illustration, there is assumed to be a foreign exchange scarto. 276 ECONOMIC ASPECTS OF PROJECT ANALYSIS and this forces use of a more costly domestic alternative and thus greatly reduces the contribution of the project to national income. The second is when an import quota imposed on products that compete with the project's output makes the contribution of the project investment to national income high, even though the cost of production per unit of output from the project is higher than the cost of competing imports. When the domestic cost of an important project input is higher than the world market price because of a quota or prohibitive tariff, the potential contribution of the proposed investment to national income Table 7-3. Economic Import Parity Value of Early Crop Maize, Central Agricultural Development Projects, Nigeria (1985 forecast prices in 1976 constant terms) Relevant steps in Value Steps in the calculation the Nigerian example perton Using shadow exchange rate F.o.b. at point of export F o.b. U.S Gulf ports No. 2 U.S. yellow corn in bulk' US$116 Add freight to point of import Freight and insurance 31 Add unloading at point of import (Included in freight estimate) Add insurance Equals c.i.f. at point of import C.i.f Lagos or Apapa US$147 Convert foreign currency Converted at an assumed shadow to domestic currency at exchange rate of-tl = shadow exchange rate US$1.47b i100 Add local port charges Landing and port charges (including cost of bags) 22 Add local transport Transport (based on a and marketing costs 350-kilometer average)' 10 to relevant market Equals value at market Wholesale value #'132 Conversion allowance if necessary (Not necessary) Deduct transport Primary marketing (includes and marketing costs assembly, cost of bags, to relevant market and intermediary margins)' - 12 Transport (based on a 350-kilometer average)c - 10 Deduct local storage, transport, Storage loss (10 percent of and marketing costs harvested weight) - 9 (if not part of project cost) Equals import parity value Import parity value at farm gate at farm gate #101 Using conversion factors F.o.b. at point of export F o.b. U.S. Gulf ports No. 2 U S. yellow corn in bulka US$116 Add freight to point of import Freight and insurance 31 Add unloading at point of import (Included in freight estimate) Add insurance Equals c.i.f. at point of import C.i.f. Lagos or Apapa US$147 Convert foreign currency Converted at official to domestic currency at exchange rate of official exchange rate N1 = US$1 62b P#91 DETERMINING ECONOMIC VALUES 277 Table 7-3 (continued) Relevant steps in Value Steps in the calculation the Nigerian example perton Convert nontraded goods Converted using standard to equivalent domestic conversion factor of 0.909b value using conversion factors Add local port charges Landing and port charges (including cost of bags, 4-22) 20 Add local transport Transport (based on a and marketing costs 350-kilometer average, 410)' 9 to relevant market Equals value at market Wholesale value 120 Conversion allowance if necessary (Not necessary) Deduct transport Primary marketing (includes and marketing costs assembly, cost of bags, to relevant market and intermediary margins, =N12)' - II Transport (based on a 350-kilometer average, *10)' - 9 Deduct local storage, transport, Storage loss (10 percent of and marketing costs harvested weight) - 8 (if not part of project cost) Equals import parity value Import parity value at farm gate at farm gate 4,'92 ' Nigerian naira. Source: Adapted from World Bank, "Supplementary Annexes to Central Agricultural Development Projects," 1370-UNI (Washington, D.C., 1976; restricted circulation), supple- ment 11, appendix 2, table 4. The format of the table is adapted from Ward, "Calculating Import and Export Parity Prices," p. 10. a. Forecast from Price Prospects for Major Primary Commodities (1976, annex 1, p. 12; see World Bank 1982a). b. For purposes of illustration, there is assumed to be a foreign exchange premium of 10 percent. Thus, the dollar value of the naira at the official exchange rate ofNA1 = US$1.62 has been divided by 1.1 to give an assumed shadow exchange rate of'NI = US$1.47 (1.62 - 1.1 = 1.47), whereas the standard conversion factor is I divided by 1 plus the foreign exchange premium, or 0.909 (1 - 1.1 = 0.909). In the appraisal report that is the source of this table, no foreign exchange premium was assumed. c. Shadow prices were assumed for transport and for primary marketing because in the financial analysis the market wage overvalued the opportunity cost of unskilled labor. The value given is the opportunity cost in naira (before applying the standard conversion factor). will be reduced by the tariff or quota. Given the policy prevailing, the project analysis will be an accurate indicator of the project's worth. Take fertilizer, for instance. If it is expensive to produce domestically, this is an indication that fertilizer production uses a large amount of scarce domestic resources relative to the resources necessary to produce some other product that could be exported to earn the foreign exchange needed to import the fertilizer from a foreign supplier. But if the domestic fertilizer must, in fact, be used for the project to move forward, then it will take a lot of domestic resources to produce the project's agricultural output, and the project will not, accordingly, make as much of a con- 278 ECONOMIC ASPECTS OF PROJECT ANALYSIS tribution to the national income as it could were imported fertilizer available. If the quota or prohibitive tariff against the input were re- moved, then the project investment would look quite different. A change in trade policy, however, will have implications ranging far beyond the boundary of the project itself, implications for both efficiencies in the economy and for noneconomic objectives. A change in trade policy may bring a wide range of changes in other prices in the economy as well as in the price of fertilizer used on nonproject farms, and to be valid an investment analysis would have to be run with the new price relations and include nonproject farms. Predicting these changes could be very difficult if the change in trade policy were significant. At best, the project analyst could rnn his analysis again using a c.i.f. price for fertilizer and making a broad guess about what the changes might be in the rest of the economy both within and outside agriculture. He could then turn to those responsible for trade policy and say that his project analysis sig- naled a need to consider with care removing the quota against fertilizer. But note that the project analysis is only a signal, not a criterion for decision; much, much more must go into a rcevaluation of trade policy than the analysis of one project. The other important case in which a change in a quota proves very difficult for the project analyst is that of a quota against imports that would compete with the output of a proposed project. If the imports are prohibited, the output of the project will sell for more in the protected market, and what otherwise might not be a very attractive project may now make sufficient contribution to national income to be justified. Again, ifpolicies are not going to be changed, this is an accurate indicator of the contribution to the national income. But if the domestic cost per unit of project output-say, apples-valued at shadow prices is greater than the c.i.f. cost of imported apples, then this is an indication that it would be more efficient from the standpoint of the economy as a whole for the project to produce something else, export it to earn foreign exchange, and then use the foreign exchange to import apples. Under the circumstances, the project analyst may want to run his analysis again using an import parity price and perhaps also adjusting some of the other price relations in the direction he thinks might prevail under a change in trade policy. He may find that domestic production would not make enough of a contribution to national income at these prices to justify the investment required. He might also want to determine the domestic resource cost of the import substitute along the lines discussed in the section of chapter 10 devoted to that topic; this will show that it costs more to save a unit of foreign exchange by producing apples domestically than the shadow exchange rate indicates the foreign exchange to be worth. His analysis has now signaled that trade policies should perhaps be reviewed. Again, it is only a signal; the analysis of this one project does not itself provide a complete decision criterion. The trade policy change will have many other effects that will be felt far beyond the boundary of the project itself. DETERMINING ECONOMIC VALUES 279 Valuing Intangible Costs and Benefits The methodology outlined for converting financial prices to economic values is one that is most appropriate for tangible costs and benefits. When intangible costs or benefits enter into investment considerations, they raise difficult issues of valuation. Intangible factors have come up frequently in earlier discussions of identifying costs and benefits and of valuing them. They comprise a whole range of considerations-economic considerations such as income distribution, number of jobs created, or regional development; national considerations such as national integration or national security; and environmental considerations that can be both ecological and aesthetic, such as the preservation of productive ecosystems, recreation benefits, or famous spots of scenic beauty. [Lee (1982) discusses ecological considera- tions to be kept in mind when designing agricultural projects for tropical regions.] The question of how to treat intangible factors most often arises when we are considering the benefits of a project. Many development projects are undertaken primarily to secure intangible benefits-education proj- ects, domestic water supply projects, and health projects are a few common ones. Intangible benefits are usually not the major concern in agricultural projects, although many agricultural and rural develop- ment projects include components such as education or rural water supply from which intangible benefits are expected. Whether in agri- cultural projects or in other kinds of projects, intangible benefits, even though universally agreed to be valuable, are nevertheless virtually impossible to value satisfactorily in monetary terms. Yet costs for these projects are in general tangible enough, and the considerations of finan- cial and economic valuation we have discussed earlier apply unambig- uously. Intangible costs are not uncommon, however, and prove just as dif- ficult to bring within a valuation system as benefits. Often costs are merely the inverse of the benefits that are sought: illiteracy, disease, unemployment, or the loss of a productive environment or treasured scenic beauty. Some costs in agricultural projects, while tangible, are very difficult to quantify and to value. Siltation, waterlogging, salinization, and soil loss are examples. These costs should not be ignored, and if they are likely to be substantial they should be treated in the project analysis in a manner analogous to intangible costs. When considering projects in which intangible benefits or costs are important, the least the project analyst can do is to identify them: lives that will be saved, jobs created, kind of education provided, region to be developed, location of a park, ecosystem or kind of scenery to be pre- served. 280 ECONOMIC ASPECTS OF PROJECT ANALYSIS Very often, the analyst can also quantify intangibles: number of lives saved, number of jobs created, number of students to be enrolled, num- ber of people expected to use a park. Even such simple quantification is often a substantial help in making an investment decision. Economists have tried repeatedly to find means to value intangibles and thus bring them within the compass of their valuation system. The benefits of education have been valued by comparing the earnings of an educated man with those of one who is uneducated. Health and sanita- tion benefits have been valued in the number of hours of lost work avoided by decreasing the incidence of disease. Nutrition benefits have been valued in terms of increased productivity. Population projects have been valued by attaching a value to the births avoided. Although work in these areas continues-especially with regard to environmental im- pact-few applied project analyses in developing countries currently attempt to use such approaches to valuing intangible costs and benefits. For one thing, such efforts generally greatly underestimate the value of the intangibles. The value of an education is much more than just the increase in income-ask any mullah, monk, or priest. Good health is a blessing far in excess of merely being able to work more hours. Good nutrition is desirable for more reasons than just increased productivity. Moreover, the methodological approaches used to value intangibles turn out to be unreliable and open to serious question. Finally, there may be moral issues involved-many who support population programs do so out of considerations that extend far beyond any benefit-cost calculation. In contemporary practice of project analysis in developing countries, the only method used to any extent to deal with intangible benefits is to determine on a present worth basis the least expensive alternative com- bination of tangible costs that will realize essentially the same intangible benefit. This is often referred to as "least-cost combination" or "cost effectiveness" (for an application of the method to sanitation projects, see Kalbermatten, Julius, and Gunnerson 1982, chapter 3). If the same education benefits can be provided by centralized schools that realize economies of scale but require buses or by more expensive smaller schools to which students can walk, which schools are cheaper? Can the same health benefits be provided at less cost by constructing fewer large hospitals but more clinics manned by paramedical personnel? By con- structing a waterborne sewerage system or by installing low-cost house- hold sanitation facilities that do not require sewers? Can the same num- ber of lives be saved more cheaply by buying up all the property rights in a flood plain and moving people out than by constructing dykes and levees? Given two park sites that would give similar recreation benefits- perhaps one that would require buying warehouse sites and another that would require extensive filling and flood control along a river-which would be cheaper? Once it is determined that the least expensive alterna- tive has been identified and its costs valued, then the subjective question can be more readily addressed: is it worth it? Interestingly enough, electricity projects are customarily analyzed DETERMINING ECONOMIC VALUES 281 using least-cost combination. The marginal value product of electricity is in general considered greatly understated by the administered price charged; in any event, much electricity is used for home lighting that is very difficult to value. In practice, most power projects simply compare alternative means of producing the same amount of power: steam gener- ating stations versus a hydroelectric dam; a large generator with trans- mission costs and several years of idle capacity versus a series of smaller stations close to the demand centers. A variation of the least-cost combination method can be used to deal with intangibles in multipurpose projects. From the total cost of the project are deducted all those costs that can be directly attributed to tangible benefits-flood damage avoided, irrigation, navigation, and the like. These costs are compared with their associated benefits to deter- mine if the purpose is worthwhile at all. Is the flood damage avoided worth the direct costs incurred? Finally, the residual costs for the project are compared with the residual, intangible benefits. Is the number of lives saved by the project worth the residual cost that must be incurred? (A method of allocating residuals was outlined in the section on joint cost allocation in chapter 6.) The problems with valuing intangibles are more common and more difficult to deal with in sectors other than agriculture. In agricultural projects, most of the benefits usually are tangible and can be valued. The costs and benefits can be compared directly to choose the highest- yielding alternative. There are, however, several aspects of intangible benefits that are frequently encountered in agricultural projects. Agri- cultural extension services, for example, are sometimes considered to give an intangible benefit in greater farmer education. For the most part, it is best to treat such costs that may give rise partly to intangible benefits-or, at least, the incremental amount of such costs-as neces- sary within a project if the total, tangible benefits are to be realized. If a dairy production project requires helping farmers to learn better sanita- tion procedures, then the extension agents who teach the procedures are essential to the success of the project, and the benefit of their effort is the tangible one of more and better milk. In rural development projects, there are often components that are hardly essential to the main production objectives and that produce generally intangible benefits. This is the case when village schools, rural water supplies, rural clinics, or even agricultural research costs are included in a project. If these components are relatively small in com- parison with total project costs, as they often are, then the problem of valuing the benefits may be ignored. But if such components form a significant part of total project cost, they probably should be separated out and treated on a least-cost combination basis. This procedure was followed in the analysis for the Korea Rural Infrastructure Project. The project included irrigation, feeder roads, community fuelwood plots, rural domestic water supply, and rural electrification. The irrigation, feeder roads, and community fuelwood components were analyzed by 282 ECONOMIC ASPECTS OF PROJECT ANALYSIS Figure 7-1, part A. Decision Tree for Determining Economic Values: Major Steps Direct transfer (Continued in part B) Traded (Continued in part C) SNontraded (Continued in part D) .......but not valued Figure 7-1, part B. Decision Tree for Determining Economic Values: Direct Transfer Payments avmt Omitted Direct transfer L payment La (Continued from part A) Cei transaction Reparmntna -- I nttpamn DETERMINING ECONOMIC VALUES 283 Figure 7-1, part C. Decision Tree for Determining Economic Values: Traded Items NomporteddImport input Exported Export wthout project parity price Continued ib rt; wirty prtect from part A.)affectc Figure 7-1, part D. Decision Tree for Determining Economic Values: Nontraded Items opportunrty cost Rent Land Purchase price Direct estimate Nonproduced -Fully employed Market wag Labor without project Project Underemployed value product input wrthout project of labor employed without project r l ful capcitySupply mndustryvMre rc operating at Make iprrc Domestlcally fulcpct'fmu pDroduced Supyids NonraedSupacity ofM grd"gc put (Continued Replae Resources saved from part A.) other-tm in from other market II production Project .Large project Prrce without output in relation to market + prrce with. . ees ew price falls 2 demandSmall project in relation to market Market price prices not affected without project Source. Adapted from Wilhiam A. Ward, "Economic Valuation Decision Tree," training material of the Economic Development Institute (EDI), CN-61 (Washington, D.C.: World Bank, 1978). 284 ECONOMIC ASPECTS OF PROJECT ANALYSIS comparing their tangible costs with their tangible benefits, but the com- ponents for rural domestic water supply and rural electrification were each dealt with separately on a least-cost combination basis. Finally, if the proposed project is one in which the output is wholly intangible, a least-cost combination approach is appropriate. This would probably be the case for agricultural projects in which the major invest- ment is in extension, agricultural education, rural water supply, rural health improvement, or research. Decision Tree for Determining Economic Values A "decision tree" for determining economic values is given in figure 7-1, parts A-D. Most issues of economic valuation in agricultural projects are covered by this diagram. The decision tree is used by taking an item to be valued in an agricultural project and tracing through the tree, following each alternative as it applies to the item until the end of the tree is reached, where a suggestion about how to value the item will be found. To illustrate, we may trace through a few common elements in agri- cultural projects. Take fertilizer to be used in an irrigation project that will produce cotton. The fertilizer is tangible, involves real resource use, is traded, is a project input, and would be imported without the project. Therefore, it is valued at the import parity price. Or take agricultural labor to be used to apply the fertilizer. It is tangible, involves real resource use, is nontraded, is a project input, is nonproduced, is labor, and would be underemployed without the project. Therefore, it is valued by taking the marginal value product of the labor in its without-project employment. (Note that labor is defined as a tangible item, a possible source of confusion in using the decision tree.) Or take a tax on the fertilizer. It is tangible, is a direct transfer payment, is a payment to or from government, and is a tax. Therefore, it is omitted from the project economic account. Or, finally, take the cotton to be produced in the project. It is tangible, involves real resource use, is traded, is a project output, and will be an export. Therefore, it is valued at the export parity price. 3 = , уа �г . r� � � � �� .�(� ��. . ��( � �� • � ' � � � �"`аа" � i,!�1 1 � � � �� ь � � '�� • � �у � � � ,f � �yl , F�, ,, � . k,�+�, :, • �..� с,�• k �.а , ��.� ti � i .�ai � � � ijJ' г� , �- i'• �1 5 i � � i� 'р�[i � � � у t � _ � . � � �i . �< + �1 � � � � !� �в�в � е С �� 1 � .. 1 / �' /� � �� ! - �f � � Rд " ^- � ' I � , � � � ^i 1 �' � � � � � Ii4 � ' � г _1 �' i� � ii�� г , � � * _ � , S � � t\ F f 5 �S � уΡ�� _ �'. ��ре r�' . "`г � �! � � •`4 '` �СС+ Т ч А' i3�� р. - � � � i � , .•.�: г . � ; � _ . � S`� �. � I�� • � � � ' � �� R � �- � ?�� у� tl д !,,,�,/ • � � , � � -� ,t 1 � '. { '5,�� 1 ��- д /��' � •' • \\ • `� _ 7/ . -� М / ! � � � ё rr,l �.r'� � _ �•� � ' � , ,�t � г k � � .У '�- � � л :� � ;f/'�+�`4 ; '. � f�� • � , � � :°� � � _ . . -- " я '�il�� .�� i � ^'� � "� � i С.. �,;, ��h�� -�. ��,�. ,� г> � � �' � '-'�- ' _ _ °" , � iR� �� ± �� r.. ' ,_� �' _ , . .'' . - �� _ �'ч �г �. � . � �: � ,�.� �ж� �; � "�/ л.��; � - э; � а.� � ; � �� У � - .'r, .• -�•в� • �О�в ��1 � -* � ��у- �i �1 . •� '�,' '� �� 16 � . , � r F . .. � м. �а ` �_ ..�71 8 Aggregating Project Accounts To ESTIMATE THE CONTRIBUTION a project makes to national income, the analyst first recasts the financial accounts-the farm budgets, the accounts for the processing industries, and the budgets for the govern- ment agencies-from financial prices to economic values. Then these values are aggregated to reach the economic incremental net benefit of the project, generally called the economic cash flow. Aggregating Farm Budgets Benefits and costs realized on individual farms in an agricultural project are aggregated to obtain the values for the project as a whole. In agricultural projects, it is most common for analysts to work with whole farm budgets. They will make a judgment about how many of each pattern farm will be included in the project and about the phasing of participation in the project. Then they will revalue each pattern farm budget to economic terms and aggregate by taking separately the benefit and cost from each pattern farm multiplied by the number of farms to reach summary on-farm benefit and cost figures for the whole project. An alternative path is to revalue the pattern whole farm budgets in economic terms and then to multiply the incremental net benefit before Facing page: Burning pearl millet stubble to permit plowing in Ghana. 287 288 ECONOMIC ASPECTS OF PROJECT ANALYSIS financing for the pattern farm by the number of farms of that pattern, add the results for all the patterns, and thereby reach a summary incremental net benefit figure for all farms in the project. If farm budgets have been laid out on a whole farm basis along the lines of chapter 4, this is a simple means to aggregate. Other analysts aggregate on the basis of unit activity crop budgets similar to those discussed in chapter 4. An estimate of the total area under each crop is made and a judgment about phasing formed. Then the benefits and costs in the crop budgets are converted to economic values, totaled separately, and entered in the summary account for the project. Which is the better approach for aggregation, unit activity crop budgets or whole farm budgets? Each has its use, and the same analyst may use one approach or the other as circumstances demand. The unit activity approach is especially convenient when the focus of the project is on a particular crop that will simply be added to existing farms without causing major reorganization. This approach was taken, for instance, in the Nucleus Estate/Smallholder Oil Palm Project in Rivers State, Nige- ria, where the typical smallholder farm budget was a 1-hectare model that was aggregated by multiplying by the 10,000 hectares proposed for planting by smallholders in the project. Costs and benefits were then aggregated separately into a summary economic account. A problem with unit activity crop budgets is that they are infrequently done on a with-and-without basis; rather, in general they are simply cast incrementally, beginning in project year 1. This means that the oppor- tunity cost of land and family labor must be estimated directly. If whole farm budgets are used, however, the with-and-without format automati- cally values correctly the opportunity cost of land and labor, as noted in chapter 4. Whole farm budgets provide a much better picture of the effects that a proposed project has on the participating farmers' family income; there- fore they give a much better idea about incentives and such considera- tions of project design as debt service timing. Of course, whole farm budgets can be used even when the focus of the project is on a particular crop, and they are almost essential if there will be a considerable reorga- nization of the farm or if new farms are to be established. A problem with using whole farm budgets is that they may lead either to awkwardly sized units or to peculiar total areas. If a 10,000-hectare area is anticipated in the project and the pattern farm is 6 hectares, then 1,667 farmers must be anticipated in the project; the odd figure gives a spurious indication of accuracy. Alternatively, if the number of partici- pating farmers is rounded to 1,700, then the pattern farm becomes 5.88 hectares, again a spurious indication of accuracy. If we instead take 1,700 farmers each with a 6-hectare holding, then the result is a project area of 10,200 hectares, itself a peculiar figure. Such anomalies are not easy to avoid. In practice, the most common approach is to use round figures for the number of farms and size of holding and to reach the area figure on this basis, even if the resultant total area is a bit awkward. AGGREGATING PROJECT ACCOUNTS 289 Some analysts have used both unit activity budgets and whole farm budgets for the same area in a project. They use the unit activity approach to estimate the incremental net benefit stream. Then they do a series of whole farm budgets to test the effect of the project on certain kinds of farmers who would not be average but toward the extremes of the distribution. What will be the effect on a very small farmer if he participates? When the sensitivity tests are run, do they show that the smallest farmers have a disproportionate risk? If so, that may have implications for the participation of small farmers and for the project design. Yet, if large farmers participate, will they stand to gain windfall advantage? Whole farm budgets are well suited to analyze these ques- tions. By using whole farm budgets in addition to a basic unit activity budget, the analyst avoids focusing only on average farms; he also avoids the anomalies in pattern farm size or total area that occur when whole farm budgets are the sole basis of aggregation. In general, despite the problem of fitting together the pattern farm and the total areas, whole farm budgets are preferable as a basis for prepar- ing agricultural project analyses. This is because whole budgets empha- size the farm family and its income as a whole and because they avoid the problem of estimating directly the opportunity cost of land and labor. Whatever aggregation path is followed, the analyst will need to allow for the phasing of participation in the project. Not all farmers may be ready to participate in a project during its first year of operation-nor is the project administration likely to be ready in the first year to include all the farmers who will eventually take part in the project. Some judgment will have to be formed both about the willingness of farmers to partici- pate and about the number of farmers the project administration will be able to handle effectively. In the Drought-Prone Areas Project in India, for example, some 225,000 farmers were expected to be reached over a seven-year period, phased so that 5 percent of the expected total would participate in the first year, an additional 7.5 percent in the second year, another 12.5 percent in the third year, and so forth. Such a long phasing period is unusual, however; most projects would be expected to reach the full number of farmers within three or four years. Other Aggregation Issues A process similar to that for farm budgets is followed for the budgets of processing industries. The accounts are first converted from financial prices to economic values. The benefits and costs are usually then carried forward separately to a summary project account. Alternatively, the incremental net benefit before financing may be carried forward. Finally, the net benefits from various government agencies are added and carried to the summary account. Since government agencies nor- mally have a net expenditure, this is often shown in the summary account as a project administrative cost or some similar entry. But if a user fee is to be charged, as might be the case for water charges and 290 ECONOMIC ASPECTS OF PROJECT ANALYSIS benefit taxes in an irrigation project, the project administration may actually run a surplus, which would then be shown as a project benefit or, perhaps, as a "negative cost" under the summary cost entry. Table 8-1, adapted from the Ghana Upper Region Agricultural De- velopment Project, is a summary account of a general form frequently Table 8-1. Economic Measures of Project Worth, Upper Region Agricultural Development Project, Ghana (thousands of Q) Project year Item 1 2 3 10-20 Inflow Incremental crop benefit 1,829 7,071 14,217 36,822 Incremental livestock benefit 763 1,065 2,542 9,482 Total inflow 2,592 8,136 16,759 46,304 Outflow On-farm production cost Incremental crop input 2,635 5,836 9,464 18,724 Incremental livestock input 299 477 385 234 Total on-farm cost 2,934 6,313 9,849 18,958 Project administrative and processing cost Crops Buildings 4,709 3,476 1,895 0 Plant, vehicles, and equipment 6,249 1,505 240 383 Salaries and allowances 1,487 1,730 1,840 482 Plant and vehicle operation 446 1,254 1,335 967 General administration 65 ( 43) 25 0 Physical contingencies 648 396 267 92 Total crop administrative and processing cost 13,604 8,318 5,602 1,924 Livestock Buildings 942 662 0 0 Plant, vehicles, and equipment 245 65 0 57 Salaries and allowances 264 275 275 215 Plant and vehicle operation 71 82 82 82 Physical contingencies 76 54 18 18 Total livestock administrative and processing cost 1,598 1,138 375 372 Total outflow 18,136 15,769 15,826 21,254 Incremental net benefit (cash flow) (15,544) ( 7,633) 933 25,050 Net present worth at 12 percent opportunity cost of capital = C85,274" Econonuc rate of return = 40 percent' Net benefit-Inve.stnient ratio at 12 percent opportnttv cost ofcaptal = 104,759/019,485 = 5.38" C Ghanaian cedis. Source: Adapted from World Bank, "Appraisal of Upper Region Agricultural Develop- ment Project, Ghana,' 106la-GH (Washington, D.C., 1976; restricted circulation), annex 11, table 18. a. Calculated from the incremental net benefit (cash flow). For details about the meth- odology of the computation, see chapter 9. AGGREGATING PROJECT ACCOUNTS 291 found. As in earlier chapters, the general categories of items included in the account appear in the text in italic type. The analyst chose to work entirely on an incremental basis instead of on a with-and-without basis. The table is divided into incremental inflow and incremental outflow. The difference between the two is the incremental net benefit (cash flow). The inflow is taken to be the incremental value of production from the project. The basic farm accounts for the crop benefit were unit activity crop budgets for several crops cast on a hectare basis. The unit activity crop budgets were revalued to economic terms and multiplied by the number of hectares expected to be included in the project, properly phased. For crops that required processing such as cotton and ground- nuts, the economic value was based on the economic export parity value at the project boundary, since the cost of processing is included in the outflow. The basic farm accounts for the livestock benefit were the pat- tern whole farm budgets for the ranches to be established. Thus, the analyst used both aggregation paths in one project-the unit activity budget for crops and the whole farm budget for the livestock ranches- according to his needs. In the outflow, the first element was the on-farm production cost for crops and livestock, which was calculated along lines parallel to those discussed for the benefits. To this was added the project administrative and processing cost, again separated into the crop production compo- nent and the livestock production component. The analyst chose to carry forward the various categories of cost for each of the units to be estab- lished under the program. Thus, there was one entry for buildings; another for plant, vehicle, and equipment operating cost; and a third for salaries and allowances. Had it suited his purpose better, the analyst could have chosen to list cost by the kind of administrative unit; he could have shown, for example, the Upper Region Project Management Unit- perhaps broken down by major subunits-the Ghana Broadcasting Cor- poration, the Farmers Service Company, the Agricultural Development Bank, the Cotton Development Board, and the like. Subtracting the outflow from the inflow gives the incremental net benefit, or cash flow, for the project as a whole. As expected, this is -negative in the early years of the project, but it becomes positive in later years. This flow would then be discounted, as discussed in chapter 9, to give the net present worth, economic rate of return, and the net benefit- investment ratio for the project as a whole. (The symbol for Ghanaian cedis is C.) A flow chart for aggregating project economic accounts is given in figure 8-1. Appendix. A Diagrammatic Project Model Some of the relations among farm budgets, processing industry accounts, government agency budgets, and the contribution a project makes to national income can perhaps be more easily visualized by 292 ECONOMIC ASPECTS OF PROJECT ANALYSIS Figure 8-1. Aggregating Project Accounts FINANCIAL ANALYSIS ECONOMIC ANALYSIS (market prices) (economic values) Budgets I- Budgets for pattern farms 2 for pattern farms or unit actrun3v or unit activity Add together crop budgets crop budgets (aggregate) (properly phased) (properly phased) either All Adjust incremental market prices net benefits to Budgets I- economic values Budgets or Project for processing 2 Direct s for processing (separately), tncreental industries transfers - industriesInrm ta (properly phased) n Tradedy phased) phased) All net benefit items incremental Nontraded benefits items and then Budgets I Budgets All for government 2 for government incremental agencies agencies costs (properly phased) a (properly phased) means of a simple diagrammatic model of a project. (This model origi- nally was developed by George B. Baldwin of the World Bank.) Measures of national income National income is usually measured either by the gross domestic product (abbreviated GDP) or by the gross national product (abbreviated GNP). Most national plans define the economic objective of development as growth of one or the other measure. The gross domestic product is defined as the value of the gross output of goods and services produced in the country less the value of the in- termediate goods and services-that is, those used to produce other goods or services. Gross national product is the same as gross domestic product except that it includes income earned abroad and excludes income transferred out of the country by foreign owners. The gross domestic product can be measured in three ways, all of which are equivalent and give the same result: (1) the value of all expen- diture on final goods and services produced (plus an allowance for home- consumed production), less imports; (2) the sum of all factor income payments, including capital consumption allowances, and (for a market price measure) all indirect taxes net of subsidies; and (3) the sum of the value added from every producing unit. Although the first measure is the most frequently used because the data are most readily available, the third is of most interest to us because it is through the value added that we link project analysis theory with na- tional income theory. AGGREGATING PROJECT ACCOUNTS 293 Value added The value added of any enterprise is the market price of the goods and services produced less the cost of materials and services purchased from others-the difference between gross output and the value of intermedi- ate consumption. Value added may be gross or net. Gross value added includes payment for taxes, interest, rent, profits, reserves for deprecia- tion, and compensation to management and other employees, including social security. Net value added excludes depreciation. For our present purposes we are interested in gross value added because it is the gross value added by all the productive enterprises in the economy that adds up to the gross domestic product. Project model Starting from this view of national income as the sum of the value added of all the productive enterprises (including, of course, projects), we may lay out a schematic picture, or diagrammatic model, of a project. (The way we will present the model is most directly applicable to the criterion of the economic rate of return discussed in chapter 9. With minor modifications, the model is equally applicable to the criteria of net present worth, benefit-cost ratio, or net benefit-investment ratio.) We can picture a project in its simplified form as in figure 8-2, the general model of a project showing real resource flows. Here, we see that the difference between what the external inputs are worth and what the final output is worth is the value added created by the project. How does the project create this value added? Obviously, through the use of its own internal resources. We may conveniently divide these internal resources into two major categories, labor and capital, as indi- cated in figure 8-2. The arrow represents the flow of output from a project-say, rice from a new irrigation scheme. The broken lines of the rectangle indicate the project boundary. The total output is made up of the contributions to the stream of output generated directly by the external inputs (say, fertilizer, pesticides, and so forth) and the contribu- tion of the project's own internal inputs of labor and capital. The value added is that amount of the total output stream which is attributable only to the contribution of the internal inputs of labor and capital. So far, we have been talking of "real" resource flows. That is, of rice or coconuts or wheat or beef cattle (or, moving outside agriculture, auto- mobiles or gasoline or consumer services). Flowing in the other direction is the value stream-the money actually paid for each of the real goods or services, or the value of each stated at shadow prices if market prices do not estimate the opportunity cost well. The project receives payment from its customers and, in turn, pays its suppliers for the external inputs it uses. What is left over is available to remunerate the internal factors of production. This more complicated 294 ECONOMIC ASPECTS OF PROJFCT ANALYSIS Figure 8-2. General Model of a Project: Real Resource Flows r ------ PROJECT ExTERNA IOurUur > > OUTPUT Internal inputs Value added Labor Capital L-4 Project boundary. Contribution of external inputs to output. Contribution of internal inputs to output. pattern is indicated in figure 8-3, the general model of a project showing economic value flows. In figure 8-3, within the broken lines of the rectangle, the project boundary, we represent the value flows that are the remuneration to internal factors of production. Note that the value added is identical to the total remuneration to all internal factors of production. The value added amounts, of course, to the difference between the value of goods and services provided by outside suppliers and the value of what is supplied by the project to consumers plus the value of unsold output, including home-consumed production. The value added, in turn, is di- vided between remuneration to labor and remuneration to capital. Labor payments include all kinds of remuneration for all kinds of labor-wages, salaries, bonuses, payments in kind, home-consumed pro- duction, consultants' fees, and social security contributions. There is a conceptual difficulty in the treatment of the manager's remuneration. Is an entrepreneur's compensation a return for his man- agement skill or a return to his capital? We resolve this, sometimes rather arbitrarily, by assuming that the manager's salary is whatever we AGGREGATING PROJECT ACCOUNTS 295 Figure 8-3. General Model of a Project: Economic Value Flows REST OF ECONOMY PROJECT Payment to outside suppliers fro ryrs less subsidies, value of home-> consumed production Remuneration to mnternal factors of production: Gross value added Labor Wages, salaries, bonuses, in-kind payment, home- consumed production, a ~ social security Incremental > net benefit (cash flow) o = ICapital - I Return of capital Depreciation Amortization '5 Return to capital (net profit) -0 Interest Income taxes Duties Reinvested earnings a I Dividends Project boundary. Payment to outside suppliers. Remuneration to internal factors of production. would have to pay to attract a manager of equal competence who con- tributes none of the capital. In agricultural project analyses, we are inclined to simplify even further. In the case of farmers who own their farms and supply most of both the labor and management skills, we are likely to attribute to the farmer only the equivalent of his wage as a laborer and nothing at all for his management skill. Anything over the farmer's wage is considered return to capital. 296 ECONOMIC ASPECTS OF PROJECT ANALYSIS Since we value labor at its going wage or at its marginal value prod- uct-its shadow price-it receives the same remuneration per unit re- gardless of its use. The residual is the incremental net benefit, which we generally call the cash flow. If we can now choose the project alternative that will maxi- mize the cash flow relative to the capital resources used, then we will know that we are at the same time maximizing the value added and, in turn, maximizing the contribution of the capital to national income. That is our macroeconomic investment objective, and that is what our project analysis enables us to do. PART FOUR Measures of Project Worth � � , -- ,:, .,. . ` � :�- . - ,�, wk е . �г. � . � � гУ- . . :'� �; � . ' _ ;� у 1-д� ' • td- � �' ,v+- /.�,�"-�,." � . � �r.' "'.1 � ' � , ��,�� ' 4 j � �� 1. 1,�. ' f f f 7l , ю, 9)tl} . � 4 ( � l � � � ^ � Z ��,' ;и� � а �-�`�� ,� � � •. ю> - . �'�• , _ � J � �::. •' .!� ( �• � А�7 '��, �� I � � . -` � � �S г а� . � . r. , п� � �'� - - - п т у 1 :� й+.;� '.rti t. - i , г � .) �Т� ~ �� - s�� . г . � • ' � f � .iJ �- ..i: � г , `г, �.р.% ." 1 У,а . у у��;- , ' м +: ' - ' �' ° �' � - 'г ' r� � , I �/ �I , 1 у� � � 4 • � � 't. � е :7- ti .у�� ''� rr �{, � •Ч� и,г �J ��j`� �� - У ц'�{а , f(¢�,, � �' �''��!++ а{�''г7у � � Si � � ��'д ,.� � � - i�9 : _ � _ я.�,�,,�,' 'J � • �` � � ,, •i г , � �:. ` • � •,, ''�� '� � �4 � f rJ �Jf�J .: • ��'д J. L _._ - - _ ,! ' �s" ' ..�л�,�: 4;r 1� " :j '�;'�,. `� т, у� г • ,�..�F��I�,y �� : ,) �• 1�r' �.:-- й. ,•' ?•t ' ' .`�г��',r ' � . _�,. r . � ��"._ � �r��; ,;� ,f rt .'� у . � и 4, вг f��,ауΡr,5 Ъл�'.�' а •�� а +': �,, � ' r ,t -'•г`{�'`�l:,:i'ti. ��R' ��'��}t��;.�.��,,� , :=7��. ,, } ' �о.г.. .' �+ i'vi ' ��i. �� л,,�г . q �� . ��` 1{ ,r yr.`�; �;_ry� ' � � ��, � ��f� � � '�f�. ,".',� ��СЭ' �' <��. ~_�: ;{ ,�лы•!�fi' ,�' ; i.;.j�:'�'�{7�'�'. 1 ,�г' � + �уl ��,J,: ,�I ;.:- i�-�, п/в • , � уΡ( �i: i�л�$ М . �j � � �! i�� L-г�'. �� • �.z�% ' �1' `,� ��'✓д'�у}дд � f� 1.в✓ "1�' "��t ,•ar. �-7!ц'�т� у�1уэ`J`-г�) е!•..(а 3' :"�i" h �у'л ' ,��'rг��?г,/,�*.'.=;�'ty;,, e�4iP��r��sv'•,.`!'�:_ '�, �л+ �f•уΡf ��..��,h,y.'/� � r,ь%„рΡ��.��.1Ч, �,�гм.'{: •г �•,,.•/�:,1'�у'�АГ.�r�%Г}({��!':��д,�'q�'�� - JГ �р.� 4' L�`. � ' 9RIP' �'� уь.'•�� е� 4 �� ' . 7г��Jю'J �G � "�д' :0 � " • �У b � л. юry!�� +, F,?+ J, r�г, а ��'г�гк}�'� �.I��°i•"-;.+�Р%=,,,+,'�Т��д��1{�� .� '`.з: ':k:`ьг�f�1 9 Comparing Project Costs and Benefits WHEN COSTS AND BENEFITS have been identified, priced, and valued, the analyst is ready to determine which among various projects to accept, which to reject. The analyst immediately confronts two problems. He must find some way to evaluate projects that will last several years and that have dif- ferently shaped future cost and benefit streams. He must also be able to evaluate projects of varying size. The usual method of addressing these two problems is through discounting. We will concentrate on four dis- counted measures suitable for application to agricultural projects: net present worth (often abbreviated NPW), internal rate of return (often abbreviated IRR), benefit-cost (often abbreviated B/c) ratio, and net bene- fit-investment (often abbreviated N/K) ratio. The arithmetic of these dis- counted measures, and the way we interpret the measures and their limitations, is exactly the same whether we are using them for financial analysis or for economic analysis. The difference is only whether we apply the techniques to financial prices or to economic values. There is an extensive and occasionally esoteric literature devoted to discounted measures of project worth. A review of that literature, or any attempt to deal with all the issues it raises, is beyond the scope of this volume. Rather, I would like to point out a few practical considerations Facing page: Digging field channels in central Luzon, Philippines. 299 300 MEASURES OF PROJECT WORTH about using discounted measures to evaluate the worth of agriculture projects and to touch upon some of the more common criticisms of the four discounted measures. If the reader wishes to proceed from this discussion, a good place to begin is with the review article by Prest and Turvey (1966) and the texts by Merrett and Sykes (1963), Bierman and Smidt (1980), and Irvin (1978). At the beginning, let me make clear two critical points. First, there is no one best technique for estimating project worth (although some are better than others, and some are especially deficient). Second, don't forget that these financial and economic measures of investment worth are only tools of decisionmaking. There are many nonquantitative and noneconomic criteria for making project decisions. The usefulness of the analytical techniques we will discuss is to improve the decisionmaking process (and to give some idea of the economic cost of noneconomic decisions), not to substitute for judgment. Undiscounted Measures of Project Worth The merits of discounting can be illustrated by an example that shows how some common undiscounted measures of project worth can be misleading. [This section owes much to Bierman and Smidt (1980).] The analyst has before him four hypothetical projects, each calling for an investment in an irrigation pump. All may be thought of as being more or less alternatives for each other, but if there were sufficient funds, all could be accepted. Since these projects are only illustrative, we will be making some highly unrealistic assumptions about irrigation in the hope of illustrating more clearly and quickly some points about project analy- sis. Later we will try to make the analysis as realistic as is worthwhile in practice. For these irrigation investments, we have invented a new kind of pump: one that is completely used up (or, perhaps to say it more tech- nically, has no residual value) after two to three years of operation. We might say that in the project area the water is so sandy that the pump wears out in two to three years. We will assume for convenience that there is no uncertainty about either the costs or returns of the projects. To emphasize that what is generally called "operation and mainte- nance cost" and what is generally considered to be "production cost" must both be included in estimating project worth, each has been given a separate column. For illustrative purposes, of course, we could just as well have combined these into one cost column called "operation, maintenance, and production cost." Table 9-1 gives details about the four alternative projects for pump irrigation. Ranking by inspection In some cases, we can tell by simply looking at the investment cost and the "shape" of the stream for the net value of incremental production COMPARING PROJECT COSIS AND BENEFITS 301 Table 9-1. Four Hypothetical Pump Irrigation Projects (thousands of currency units) Incremental cost Value of incremental Net Operation production value of Capital and Produc- (gross incremental Year items maintenance tion Gross benefit) productiona Project I 1 30,000 - - 30,000 - - 2 - 2,000 3,000 5,000 20,000 15,000 3 - 2,000 3,000 5,000 20,000 15,000 4 - -- - Total 30,000 4,000 6,000 40,000 40,000 30,000 Project ii 1 30,000 - - 30,000 - - 2 - 2,000 3,000 5,000 20,000 15,000 3 - 2,000 3,000 5,000 20,000 15,000 4 - 2,000 3,000 5,000 9,100 4,100 Total 30,000 6,000 9,000 45,000 49,100 34,100 Project III 1 30,000 - - 30,000 - - 2 - 2,000 3,000 5,000 7,000 2,000 3 - 2,000 3,000 5,000 19,000 14,000 4 - 2,000 3,000 5,000 31,000 26,000 Total 30,000 6,000 9,000 45,000 57,000 42,000 Project iv I 30,000 - - 30,000 - - 2 - 2,000 3,000 5,000 7,000 2,000 3 - 2,000 3,000 5,000 31,000 26,000 4 - 2,000 3,000 5,000 19,000 14,000 Total 30,000 6,000 9,000 45,000 57,000 42,000 a. The net value of incremental production is the value of incremental production less the operation and maintenance cost and the production cost. that one project should be accepted over another if we must choose. (The shape of a stream of values refers to the times when the values occur. Use of the term derives from graphing values over time in a manner similar to that in the graph in the bottom part of table 9-12.) In general, there are two such instances: (1) with the same investment, two projects produce the same net value of incremental production for a period, but one continues to earn longer than the other (in the examples of table 9-1, we would choose project n rather than project I); (2) in other instances, for the same investment, the total net value of incremental production may be the same, but one project has more of the flow earlier in the time sequence (thus, in table 9-1 we would choose project iv rather than project Iii; we cannot tell by inspection, however, if project iv would be preferred to project ii-more elaborate analysis is necessary). In many cases, projects can indeed be examined and rejected on the basis of inspection. A clear-cut case might be two alternative investments in irrigation, one of which will cost more but yield no more return. Most people would probably not even consider such a choice project analysis; they would simply look for the cheapest means to realize a given end. 302 MEASURES OF PROJECT WORTH Payback period The payback period is the length of time from the beginning of the project until the net value of the incremental production stream reaches the total amount of the capital investment. The payback period for the four pump irrigation alternatives is shown in table 9-2. The payback period is a common, rough means of choosing among investments in business enterprises, especially when the choice entails a high degree of risk. In agricultural projects, however, it is not often used. As a measure of investment worth, the payback period has two impor- tant weaknesses. First, it fails to consider earnings after the payback period. Both project i and project ii have the same payback period of three years, but we know by inspection that project ii will continue to return benefits in the third year, whereas project i will not. Hence, the payback period is an inadequate criterion for choice between these two alternatives, one of which we know by inspection to be better than the other. The second weakness of the payback period as a measure of investment worth is that it does not adequately take into consideration the timing of proceeds. Suppose we modify projects iii and iv so that each has a capital cost of $42,000. Now each has a payback period of four years, and they have equal rank or order of preference for undertaking alternative invest- ments. Yet we know by inspection that we would choose project iv over project iii because more of the returns to project iv are realized earlier. This is obviously desirable, since the earlier a benefit is received, the earlier it can be reinvested (or consumed)-hence, the more valuable it is. Proceeds per unit of outlay Investments are sometimes ranked by the proceeds per unit of outlay, which is the total net value of incremental production divided by the total amount of the investment as shown in table 9-3. By this criterion, we find that projects i and ii are correctly ranked. But projects i and iv receive equal rank, although we know by simple inspection that we would choose project iv because its returns are re- ceived earlier. Here, again, the criterion of proceeds per unit of outlay fails to consider timing; money to be received in the future weighs as heavily as money in hand today. Table 9-2. Payback Period, Four Hypothetical Pump Inigation Projects Payback period Project (years) Rank I 3.0 1 n 3.0 1 I 3.5 4 Iv 3.1 3 COMPARING PROJECT COSTS AND BENEFITS 303 Table 9-3. Proceeds per Unit of Outlay, Four Hypothetical Pump Irrigation Projects (thousands of currency units) Total net Incremental cost value of Proceeds incremental per unit Project Capital items production of outlay Rank I 30,000 30,000 1.00 4 1n 30,000 34,100 1.14 3 111 30,000 42,000 1.40 1 IV 30,000 42,000 1.40 1 Average annual proceeds per unit of outlay Another criterion for investment choice is the average annual proceeds per unit of outlay, which is obviously related to proceeds per unit of outlay. To calculate this measure, the total of the net value of in- cremental production is first divided by the number of years it will be realized and then this average of the annual proceeds is divided by the original outlay for capital items. Table 9-4 illustrates the measure. This investment criterion has a very serious flaw. By failing to take into consideration the length of time of the benefit stream, it automatically introduces a serious bias toward short-lived investments with high cash proceeds. We can see how this operates: project i ranks much better than project ii, although we know by simple inspection that project ii is the project we would choose. Similarly, the criterion cannot choose between projects in and iv, although, again by inspection, we know we would prefer project iv because it returns its benefits earlier. This criterion is misleading because it seems to allow for time by introducing "annual" into the terminology. Average income on book value of the investment A final undiscounted measure of investment worth is the average income on the book value of the investment. This is the ratio of average income to the book value of the assets (that is, the value after subtracting Table 9-4. Average Annual Proceeds per Unit of Outlay, Four Hypothetical Pump Irrigation Projects (thousands of currency units) Incremental Average cost Net Average annual value of net value of proceeds Capital incremental incremental per unit Project items production production of outlay Rank I 30,000 30,000 15,000 0.50 1 1n 30,000 34,100 11,367 0.38 4 m11 30,000 42,000 14,000 0.47 2 Iv 30,000 42,000 14,000 0.47 2 304 MEASURES OF PROJECT WORTH depreciation) stated in percentage terms. This measure is a useful and commonly used way of assessing the performance of an individual firm. Because it is widely known as a measure of performance, it is also sometimes used as an investment criterion. For purposes of illustration, we will assume straight-line depreciation of our irrigation projects and thus will compute the average book value by dividing the investment by two. Table 9-5 shows this measure. Although this procedure correctly chooses between projects i and ii, it fails to choose between projects iii and iv because it does not take adequate account of the timing of the benefit stream. We can see that all these measures of investment worth share a com- mon weakness: they fail to take into account adequately the timing of the benefit stream. In the case of ordinary inspection, there was no way of choosing between projects ii and Iv; in any event, if the projects were much more complex than these oversimplified examples, the projects would be too complicated to rank by inspection. As for the other mea- sures, they all founder on the problem of timing. The Time Value of Money A bird in hand is worth two in the bush. Mas vale pajaro en mano que cien volando. Un tiens vaut mieux que deux tu l'auras. ~~~~~~~~ L7'- k-- y - I QA -9 '- As the folk wisdom of people through the ages has recognized, present values are better than the same values in the future, and earlier returns are better than later. We can use the principle of these proverbs to overcome the weaknesses of the undiscounted measures of project worth we have considered and include a time dimension in our evaluation through the use of discounting. Discounting is essentially a technique by which one can "reduce" future benefit and cost streams to their "present worth." Then we may consider the differences between these present worths (the net present worth), determine what discount rate would be Table 9-5. Average Income on Book Value, Four Hypothetical Pump Irrigation Projects (thousands of currency units) Average net Average Average value of income income Incremental Annual (proceeds Average on book production depre- less book value Project (proceeds) ciation depreciation) value (percent) Rank I 15,000 15,000 0 15,000 0 4 n 11,367 10,000 1,367 15,000 9 3 In 14,000 10,000 4,000 15,000 27 1 Iv 14,000 10,000 4,000 15,000 27 1 COMPARING PROJECT COSTS AND BENEFITS 305 necessary to make the net present worth equal to zero (a measure of the interest-paying capacity of the project known as the internal rate of return), derive a ratio of the present worths of the benefit stream and the cost stream (the benefit-cost ratio), or compare the present worth of the net benefits with the present worth of the investment (the net benefit- investment ratio). At first glance discounting may seem complicated and abstract. In practice it is not. Interest If we lend our money to someone to use, we usually can expect to be paid interest for the use of that money. In the same manner, banks, cooperatives, and credit unions will pay interest on savings deposits. How much interest will be paid varies from time to time and also with anticipated inflation and the chances that the borrowed money may not be repaid either on time or at all. The principle, however, is well known and simple. Economists generally explain interest as arising for one of two reasons, although many others are sometimes suggested. The simplest explana- tion is that, if we lend money to someone else, we are deferring until the future the possibility of using that money for our own present pleasures. If we do this we are entitled to a reward-and interest is that reward. Another explanation, similar but rather better, is that interest is related to current income forgone. If a farmer lends money to his neighbor, on the one hand the farmer is passing up the opportunity to use that money for some productive purpose of his own-say, to increase his use of fertilizer. On the other hand, his neighbor is gaining the use of the money to put to another productive purpose-say, to increase the amount of fertilizer he applies to his crops. It is only reasonable that the lender be compensated for the income he has forgone and that the borrower pay something for his use of the lender's money. Compounding Consider a case in which the going interest rate is 5 percent a year and a one-year loan of J$1,000 is made on December 31. (The symbol for Jamaican dollars is J$.) The-following December 31 the borrower will owe J$50 interest (1,000 x 0.05 = 50). Since the borrower must also repay the amount of the principal, he must pay a total of J$1,050 (1,000 + 50 = 1,050). (As we noted in chapter 4 in connection with debt service, in interest computations it is easier to calculate the total of both principal and interest at one time by multiplying the principal by 1 plus the interest rate stated in decimal form. The "1" then covers the principal repayment, and the decimal statement of the interest rate covers the interest repayment. We would then calculate the repayment in this instance as 1,000 x 1.05 = 1,050.) Suppose the borrower wants to keep the money for two years. He must pay 5 percent for the use of the money for the first year; for the second year he must pay an additional 5 percent. In addition, of course, he must 306 MEASURES OF PROJECT WORTH pay interest on the amount he would have paid the lender at the end of the first year-that is, he must pay "compound" interest. Thus: Amount at One plus Amount at beginning of year (J$) interest rate end of year (J$) 1990 1,000 1991 1,000 x 1.05 = 1,050 1992 1,050 x 1.05 = 1,102 1993 1,102 x 1.05 = 1,157 1994 1,157 x 1.05 = 1,215 1995 1,215 x 105 = 1,276 Let us note two accounting conventions. The first is that interest is generally stated on an annual basis. Hence, if we say a loan is made at 5 percent, it is implied that we mean 5 percent a year. Interest is sometimes compounded monthly or quarterly or even continuously, but in project analysis we generally assume that the period we are talking about is a year. The second accounting convention is that the money is borrowed at the end of a period (say, midnight December 31, 1990-which is, of course, the same as the first instant of January 1, 1991) and is returned on the last day of a period (say, December 31, 1995). Another widely used accounting convention is followed in this book, although it is not as universal as the conventions for the period for which interest is paid and the assumed dates. That is, the present (or the day just before the beginning of the project period) will be noted as to and the end of the first year noted as t1, so that money is lent today, or to, and interest is paid at the end of the first year, or ti. (This causes some difficulty later, when we talk about investment, but is clear enough for the present.) Let us take another series for illustration. Suppose we were to lend out J$817 for five project years (to through ts), at 8 percent interest: Calendar Amount at One plus Amount at year beginning of year (J$) interest rate end ofyear (JS) to 817 t1 1991 817 x 1 08 = 882 t2 1992 882 x 1.08 = 953 13 1993 953 x 1.08 = 1,029 t 1994 1,029 x 108 = 1,111 ts 1995 1,111 x 108 = 1,200 Hence, if we were to lend out J$817 for five years at 8 percent annual interest, compounded, at the end of the fifth year the total of J$1,200 would be due to be repaid. In practice, it is cumbersome to calculate compound interest in the manner we have been using here. A "compounding table" is usually used to simplify the computation. A convenient set is Compounding and Dis- counting Tables for Project Evaluation (Gittinger 1973), but there are many other, equivalent sets of tables available. Compounding may also be done by using a simple electronic calculator as discussed in chapter 10, the section "Calculator Applications in Project Analysis." To illustrate how the compounding tables are used, we may consider the table for 8 percent from Compounding and Discounting Tables for COMPARING PROJECT COSTS AND BENEFITS 307 Project Evaluation [the relevant portion is reproduced from Gittinger (1973) in compounding and discounting table 2]. For our purposes, each line refers to a year, but it can also be interpreted as referring to any other compounding period. At the head of each column is stated what that column indicates. We are interested in the first column on the left-hand page entitled "Compounding Factor for 1-What an initial amount be- comes when growing at compound interest." This is often called the compound interest factor. Now, if we want to know what will be due when we lend J$817 for five years at 8 percent interest, we look down the first column opposite the fifth period to find the compounding factor, which is 1.469 rounded to three decimals. To find out how much is due, we multiply the amount of the initial loan by the compounding factor for the proper number of years to obtain J$1,200 (817 x 1.469 = 1,200). For most project purposes, given the nature of the underlying data, it will be accurate enough to carry out factors to no more than three decimal places. Note that the factors in compounding and discounting tables are com- puted assuming they fall on the last day of the period for which they are computed. Thus the column in a table reading "year" or "period" really is for the "end of year" or "end of period." COMPOUNDING AND DISCOUNTING TABLES 2. Compounding Factor for 1, 8 Percent Interest RATE 8% COMPOUNDING FACTOR FOR 1 What an initial amount becomes when growing at Year compound interest 1 1080000 2 1.166400 3 1259712 4 1360489 5 1469 8 6 1586874 7 1.713824 8 1.850 930 9 1.999 005 10 2158925 11 2331 639 12 2518170 13 2.719 624 14 2 937 194 15 2 169 16 3425943 17 3700018 Source: Gittinger (1973), p. 16. 308 MEASURES OF PROJECT WORTH The shortcut of using tables is obviously a great convenience. If, for instance, we want to lend the same J$817 at 8 percent interest for 15 years, we can find out very quickly that J$2,592 will be due at the end of that period of time (817 x 3.172 = 2,592). Discounting (present worth) Now suppose we ask a somewhat different question. If a borrower promises to pay us J$1,200 at the end of five years and an interest rate of 8 percent is assumed, how much is that promise worth to us today? Put another way, what is the present worth of J$1,200 five years in the future if the interest rate is assumed to be 8 percent? To answer the question, we must divide the amount due by 1.08 for each project year, as follows: Amount at Amount at Calendar end of year One plus beginning year (J$) interest rate of year (J$) t5 1995 1,200 - 1 08 1,111 14 1994 1,111 - 1.08 1,029 t3 1993 1,029 - 1.08 953 t2 1992 953 - 1.08 = 882 t 1991 882 - 1.08 = 817 to 1990 817 Or, the present worth of J$1,200 five years in the future is J$817. Note that the calculation we have laboriously gone through is exactly upside down from what we had done earlier for compound interest. Then we asked what would be the amount to be repaid five years in the future if we loaned J$817 today at 8 percent compound interest, and we found that the amount repayable would be J$1,200. Turning the question up- side down, we asked what would be the present worth of J$1,200 paid five years in the future assuming an interest rate of 8 percent; we computed that value to be J$817. This process of finding the present worth of a future value is called "discounting." The interest rate assumed for discounting is the "dis- count rate." The only variation is the point of view. The interest rate used for compounding assumes a viewpoint from here to the future, whereas discounting looks backward from the future to the present. Again, it is laborious to calculate this in the manner illustrated, so "discounting tables" normally are used, or factors are calculated using a simple electronic calculator as noted in chapter 10 (the section "Calcula- tor Applications in Project Analysis"). If one turns to the table for 8 percent in Compounding and Discounting Tables for Project Evaluation, on the right-hand page one finds the column entitled "Discount factor- How much I at a future date is worth today" at an 8 percent discount rate (which is the same as saying an 8 percent interest rate). The relevant portion is reproduced in compounding and discounting table 3. This column gives the discount factor for 8 percent. This is often called the present worth factor. Opposite the fifth year we find the value of 0.681 (rounded to three decimals). To find the present worth to us of J$1,200 COMPARING PROJECT COSTS AND BENEFITS 309 COMPOUNDING AND DISCOUNTING TABLES 3. Discount Factor, 8 Percent Interest RATE 8% DISCOUNT FACTOR How much 1 at a future date sworth today Year 925926 1 857 339 2 793 832 3 735 030 4 _ 680 583) 5 630 170 6 583 490 7 540 269 8 500 249 9 463 193 10 428883 11 397 114 12 367 698 13 340461 14 315242 15 Source: Gittinger (1973), p 17. received five years in the future, we multiply the amount due in the future by the discount factor for the fifth year to obtain J$817 (1,200 x 0.681 = 817). The same discounting series, rounded to three decimals, is reproduced in the summary discount factor table (compounding and discounting table 6) in appendix B. The intervals are chosen to be convenient for project analysis, and for most project purposes these three-place tables are sufficient and may be more convenient. We may use these summary tables to illustrate again how to compute present worth. What is the present worth to us of M$6,438 received nine years in the future if the discount rate is 15 percent? (The symbol for Malaysian ringgats is M$.) The relevant portion is reproduced in compounding and discounting table 4. We search out the column for 15 percent, and opposite the ninth period we find 0.284. Now we multiply the future amount by the discount factor to obtain the present worth of M$1,828 (6,438 x 0.284 = 1,828). Present worth of a stream of future income Instead of someone promising to pay a single amount in some future year, suppose we receive a stream of income for a period of years. What would be the present worth to us today of that stream of future income? 310 MEASURES OF PROJECT WORTH COMPOUNDING AND DISCOUNTING TABLES 4. Discount Factor, Various Rates DISCOUNT FACTOR-How much 1 at a future date is worth today. Year 1% 3% 5% 6% 8% 10% 12% 14% 15% 16% 18% 1 990 971 952 943 926 909 893 877 870 862 847 2 980 943 907 890 857 826 797 769 756 743 718 3 971 915 864 840 794 751 712 675 658 641 609 4 961 888 823 792 735 683 636 592 572 552 516 5 951 863 784 747 681 621 567 519 497 476 437 6 942 837 746 705 630 564 507 456 432 410 370 7 933 813 711 665 583 513 452 400 376 354 314 8 923 789 677 627 540 467 404 351 327 305 266 9 914 766 645 592 500 424 361 308 284 263 225 10 905 744 614 558 463 386 322 270 247 227 191 Source: Gittinger (1973), p. 102. This is a common question. An agricultural project often will return the same benefit in each of several years, and we need to know the present worth of that future income stream to know how much we are justified in investing today to receive that income stream. To resolve this question, we will again need to know the interest rate, the period of time we are talking about, and, of course, the amount of the income stream. Suppose we take the M$6,438 noted above and assume we are to receive that amount at the end of each year for nine project years (t, through t9). We can discount that income stream back to the present for each year using the discount factors from the column for 15 percent in compounding and discounting table 4: Discount factor Calendar Amount to (present worth factor) Present year be received (MS) at 15 percent worth (MS) 1991 6,438 x 0.870 5,601 t2 1992 6,438 x 0.756 = 4,867 t3 1993 6,438 x 0.658 = 4,236 t4 1994 6,438 x 0.572 = 3,683 ts 1995 6,438 x 0.497 = 3,200 t6 1996 6,438 x 0.432 = 2,781 t7 1997 6,438 x 0.376 = 2,421 t8 1998 6,438 x 0.327 = 2,105 t9 1999 6,438 x 0.284 = 1,828 Total 57,942 4.772 30,722 Thus, the present worth of M$6,438 received yearly for nine years at a discount rate (which is, of course, a rate of interest) assumed to be 15 percent is M$30,722. That is, the present worth is the sum of all the present worths for all the years together. (Note that, although the total undiscounted money value of the income stream is M$57,942, the present worth is not that amount. Clearly, M$6,438 received nine years in the future is not worth M$6,438 to us today; that is what discounting is all about.) Working out the present worth of a future income stream by this means COMPARING PROJECT COSTS AND BENEFITS 311 is a little awkward and time consuming. It is faster if we just take the sum of the discount factors (that is, present worth factors) and multiply by the annual income to be received, to obtain the present worth of M$30,722 (6,438 x 4.772 = 30,722). We can use discounting tables directly to find the present worth of a future income stream. In the 15 percent tables in Compounding and Discounting Tables for Project Evaluation, the second column on the right-hand page is entitled "Present worth of an annuity-How much I received or paid annually for X years is worth today." (An annuity is an amount payable yearly or at other regular intervals.) This column gives us the present worth of a future income stream of 1 currency unit a year. The same series, rounded to three decimals, is reproduced in the sum- mary present worth of an annuity factor table (compounding and dis- counting table 7) in appendix B and is reproduced in part in compound- ing and discounting table 5. Note that the present worth of an annuity is simply the running subtotal of the discount factors. Thus, in the first year the present-worth of an annuity factor and the discount factor for 15 percent both are 0.870. In the second year, however, the discount factor is 0.756. If we received the same income in both the first year and the second year, the present worth of the two-year income stream would be the annual amount received multiplied by the sum of the two present worth factors, 1.626 (0.870 + 0.756 = 1.626). If we look now at the value in compounding and discounting table 5 for the present worth of an annuity for 15 percent for two years, we will find that it is 1.626, and we have saved ourselves the trouble of adding up the discount factor column as we go along. We can try another example. What is the present worth of P12,869 received annually for 14 years if the discount rate is 8 percent? (The COMPOUNDING AND DISCOUNTING TABLES 5. Annuity Factor, Various Rates PRESENT WORTH OF AN ANNUITY FACTOR- How much 1 received or paid annually for X years is worth today. Year 1% 3% 5% 6% 8% 10% 12% 14% 15% 16% 18% 1 990 971 952 943 926 .909 893 877 870 862 847 2 1970 1913 1.859 1833 1783 1 736 1690 1.647 1) 1605 1566 3 2.941 2.829 2 723 2.673 2 577 2 487 2.402 2322 2 2246 2 174 4 3.902 3717 3546 3465 3.312 3170 3037 2914 '285 2798 2690 5 4853 4.580 4,329 4.212 3993 3791 3605 3433 33 2 3.274 3127 6 5.795 -5.417 5.076 4.917 4623 4.355 4.111 3 88v 3784 3685 3498 7 6.728 6230 5786 5582 5.206 4868 4564 4288 4160 4039 3812 8 7.652 7020 6.463 6210 5747 5335 4.968 4639 4487 4344 4078 9 8.566 7.786 7 108 6.802 6247 5 759 5 328 4 946 Q 772) 4 607 4 303 10 9.471 8530 7722 7360 6710 6145 5.650 5216 5019 4833 4494 11 10.368 9 253 8 306 7 887 7.139 6.495 5.938 5.453 5 234 5 029 4.656 12 11.255 9.954 8863 8.384 7.536 6.814 6194 5.660 5421 5 197 4793 13 12134 10635 9394 8853 7904 7 103 6424 5842 5583 5342 4910 14 13004 11296 9899 9 295 (8 244,. 7367 6628 6002 5724 5468 5008 15 13865 11.938 10380 9712 8559 7606 6811 6142 5847 5575 5092 Source: Gittinger (1973), p. 104. 312 MEASURES OF PROJECT WORTH symbol for Philippine pesos is P.) In the table for 8 percent in Compound- ing and Discounting Tables for Project Evaluation, or in the 8 percent column in compounding and discounting table 5, opposite the fourteenth year we find a value of 8.244. Multiplying the amount to be received annually of P12,869 by the present worth of an annuity factor at a discount rate of 8 percent for fourteen years, we find the present worth of the stream to be P106,092 (12,869 x 8.244 = 106,092). Put another way, if the going rate of interest is 8 percent, then we could afford to invest P106,092 in an enterprise that would yield us an annual return of P12,869 for each of fourteen years. Many investments, of course, do not begin to repay us the first year. Suppose we are thinking of oil palm, which begins to bear about the fifth year and continues to produce commercially for about twenty years. In this case, we are concerned only with the present worth of a future income stream beginning with the fifth year and continuing through the twenty-fourth year. To illustrate how we may determine the present worth of this future income stream, let us return to the example in Malaysian ringgats given above. Suppose our hypothetical investment, instead of paying us M$6,438 each project year from the first through the ninth year, would only repay M$6,438 each year beginning with the fifth project year and continuing through the ninth (to through tq). What would be the present worth of that income stream assuming the same 15 percent discount rate? Discount factor Calendar Amount to (present worth factor) Present year be received (MS) at 15 percent worth (M$) t5 1995 6,438 x 0.497 3,200 t6 1996 6,438 x 0.432 = 2,781 t7 1997 6,438 x 0.376 = 2,421 t8 1998 6,438 x 0.327 = 2,105 t9 1999 6,438 x 0.284 = 1,828 Total 32,190 1.916 12,335 Thus, an income stream of M$6,438 received from the fifth through the ninth project years at a discount rate of 15 percent has a present worth to us of M$12,335 today. Note that we could have calculated the present worth of our income stream by multiplying the M$6,438 received annually by the sum of the discount factors for the fifth through the ninth years (6,438 x 1.916 - 12,335). For just five years, it is easy enough to add the discount factors, but when we are working with longer periods, it is easier to use a shortcut. From the present worth of an annuity factor for an income stream received for the whole period we simply subtract the present worth of an annuity factor for the income stream for the period before the future income begins. Referring to the present worth of an annuity column in the table for 15 percent in Compounding and Discounting Tables for Project Evaluation, to compounding and discounting table 5, or to the COMPARING PROJECT COSTS AND BENEFITS 313 summary present worth of an annuity factor table in appendix B, the present worth of an annuity factor for nine years at 15 percent is 4.772 and, for four years at 15 percent, 2.855. Now we subtract: Present worth of an annuity factor for nine years at 15 percent 4.772 Less present worth of an annuity factor for four years at 15 percent -2.855 Equals present worth of an annuity factor for fifth through ninth years at 15 percent 1.917 In this case, we would have been off by one point because of rounding. Do not overlook that, if we want values for the fifth through the ninth project years, we subtract the figure for the fourth (not the fifth) year from the figure for the ninth year, since we want a factor that represents the years from five through nine inclusive. If the discount factors are always totaled when the computation is laid out, this provides an internal check that they have been correctly listed without an error in computation or an error in subtracting the wrong year. When the discount factors are totaled, the sum will equal the present worth of an annuity factor for the number of years in the com- putation. It is uncommon for rounding errors to be greater than 0.001. Discounted Measures of Project Worth The technique of discounting permits us to determine whether to accept for implementation projects that have variously shaped time streams-that is, patterns of when costs and benefits fall during the life of the project that differ from one another-and that are of different dura- tions. The most common means of doing this is to subtract year-by-year the costs from the benefits to arrive at the incremental net benefit stream-the so-called cash flow-and then to discount that. This approach will give one of three discounted cash flow measures of project worth: the net present worth, the internal rate of return, or the net benefit-investment ratio. Another discounted measure of project worth is to find the present worths of the cost and benefit streams separately and then to divide the present worth of the benefit stream by the present worth of the cost stream to obtain the benefit-cost ratio. Because the benefit and cost streams are discounted, the benefit-cost ratio is a dis- counted measure of project worth. But because the benefit and cost streams are discounted separately rather than subtracted from one another year-by-year, the benefit-cost ratio is not a discounted cash flow technique. Choosing the discount rate To be able to use discounted measures of project worth, we must decide upon the discount rate to be used for calculating the net present worth, the benefit-cost ratio, the net benefit-investment ratio, or the rate below 314 MEASURES OF PROJECT WORTH which it will be unacceptable for the internal rate of return to fall-the so-called "cut-off rate." For financial analysis, the discount or cut-off rate is usually the mar- ginal cost of money to the farm or firm for which the analysis is being done. This often will be the rate at which the enterprise is able to borrow money. If the incremental capital to be obtained is a mixture of equity and borrowed capital, the discount rate will have to be weighted to take account of the return necessary to attract equity capital on the one hand and the borrowing rate on the other [(equity capital x return needed to attract equity capital + total capital) + (borrowed capital x borrowing rate + total capital) = discount rate]. For economic analysis using efficiency prices, there are two rates that might be chosen and a third that is sometimes proposed. Probably the best discount or cut-off rate to use is the "opportunity cost of capital." This is the rate that will result in utilization of all capital in the economy if all possible investments are undertaken that yield that much or more return. It would be the return on the last or marginal investment made that uses up the last of the available capital. If set perfectly, the rate would reflect the choice made by the society as a whole between present and future returns, and, hence, the amount of total income the society is willing to save. Although good as a theoretical definition, this is difficult to apply as a practical working tool. No one knows what the opportunity cost of capital really is. In most developing countries, it is assumed to be somewhere between 8 and 15 percent in real terms. A common choice is 12 percent, and we will use that rate in the illustrative examples in this chapter. A second discount rate that might be chosen for economic analysis is the borrowing rate the nation must pay to finance the project. This is most commonly proposed when the country expects to borrow abroad for investment projects. Using the borrowing rate, however, has the undesirable result that the selection of projects will be influenced by the financial terms available and will not be based solely on the relative contribution of projects to national income. It is best to break the link between choosing projects and financing them-to choose the best selec- tion of projects given the resources available and the ability to prepare them and then to set out to obtain the best terms possible for external financing. A third rate sometimes proposed is the "social time preference rate." It is suggested that the discount attached to future returns by the society as a whole is different from the discount individuals would use. It is usually felt that the society has a longer time horizon, so that its discount rate would be lower. This implies that a different (generally lower) discount rate would be used for public projects than for private projects, and this gives rise to some awkward problems of allocation both in theory and in application. The social time preference rate would differ from the oppor- tunity cost of capital in that the opportunity cost of capital derives from both public and private investment activities and gives the same weight to future returns from both kinds of activities. COMPARING PROJECT COSTS AND BENEFITS 315 [When social weighting is used, two other discount rates become im- portant, the accounting rate of interest and the consumption rate of interest. Since the analytical system presented here is based on efficiency prices only, these rates need not concern us. They are discussed in Little and Mirrlees (1974) and Squire and van der Tak (1975).] Note that financial rates of interest, such as government borrowing rates or the prime lending rate, are generally too low to justify their use in economic analysis of projects. Indeed, when the rate of inflation is high, these rates may even be negative in real terms. Discounting convention for project analysis In World Bank project analyses, both costs and benefits are discounted beginning with the first project year, and that is the convention adopted in this book. Some international agencies and many private firms begin discounting only with the second project year. Their line of reasoning is that investment must be made before the first year is ended, so how can one say that it should be discounted-that is, that the present worth in the first year is something less than the actual face value? The reasons for the accounting convention adopted here are somewhat arbitrary. First, it is convenient to begin discounting with the first year so that the project years and the discounting periods are the same-that is, project year 1 is discounted using the factor for the first period, and so forth. So long as this accounting convention is consistently observed, it will not introduce a bias or consistent error in the analysis of projects evaluated by dis- counted measures of project worth. Second, costs in actual practice are paid out during the course of each year, not all on January 1, and to allow for this on something like a day-to-day basis (or even a quarterly basis) is too complicated to be worth any added precision that might be realized. We may illustrate the effect of the alternative conventions by examin- ing the discounted cost stream laid out in table 9-6. (Note that the factor for discounting period 0 at any discount rate is 1-in other words, year 0 is undiscounted.) We can see that the effect of changing the first applica- tion of discounting from year I to year 2 is to increase the sum of the stream of present worths by the proportion of the discount factor, in this case by 12 percent [(22.47 - 20.06) + 20.06 x 100 = 12)]. Derivation of Incremental Net Benefit (Incremental Cash Flow) When we consider a project, we see it as earning a gross benefit stream from which we must deduct the capital investment and pay the operating costs-the costs of machinery, fertilizer, pesticides, hired labor, manage- ment, consultants, and the like. What is then left over is a residual (which will likely be negative in the early years of the project) that is available to recover the investment made in the project (the return of capital) and to compensate for the use of the resources invested in the project (the return 316 MEASURES OF PROJECT WORTH Table 9-6. Discounting from Project Year I and from Project Year 2 Compared (currency units) Discounting from year 1 Discounting from year 2 Discount- Discount Present Discount- Discount Present Project ing factor worth ing factor worth year Amount period 12% 12% period 12% 12% 1 1.09 1 0893 0.97 0 1.000 1.09 2 4.83 2 0.797 3 85 1 0.893 4.31 3 5.68 3 0.712 4.04 2 0.797 4.53 4 4.50 4 0.636 2.86 3 0.712 3.20 5 1.99 5 0.567 1.13 4 0.636 1.27 6 0.67 6 0.507 0.34 5 0.567 0.38 7 0.97 7 0.452 0.44 6 0.507 0.49 8 1 30 8 0.404 0.53 7 0.452 0.59 9 1.62 9 0.361 0.58 8 0.404 0.65 10-30 1 95" 10-30 2.727b 5.32 9-29 3 054' 5.96 Total 63 60 8.056 20.06 9.022 22.47 a Annual amount for years 10 through 30 inclusive To reach column total, this amount must be included 21 times. b. Present worth of an annuity factor for years 10 through 30 inclusive See the subsec- tion on "Present worth of a stream of future income" for method of computation. c. Present worth of an annuity factor for years 9 through 29 inclusive. See the subsection on "Present worth of a stream of future income" for method of computation. to or on capital). This residual is the net benefit stream. Deducting the without-project net benefit gives the incremental net benefit stream. These streams are commonly called cash flows because discounted mea- sures of project worth were originally developed for use in business. The net benefit flow was distinguished from the profit of the business partly by the fact that no allowance for depreciation was taken from the benefit stream, which thus included all the cash generated. The definition of incremental net benefit or incremental cash flow applies specifically to investment analysis. Accountants often have a somewhat different definition in mind when they use the term. In accounting, the cash flow is essentially the sum of the profit plus the depreciation allowance, usually computed after payment of taxes. The major characteristic of the incremental net benefit stream or incremental cash flow is that it includes, without differentiating, both the return ofcapital and the return to capital. In other words, to compute the incremental net benefit or cash flow we do not deduct from the gross benefit any allowance for depreciation (that is, return of capital) nor any allowance for interest on the capital employed that has been supplied by the entity for which we are doing the analysis. We do not deduct depreciation because the incremental net benefit stream already allows for the return of capital over the life of the project. Depreciation is an accounting concept necessary when accounts are to be prepared for one year at a time (not prepared as a projection over the life of the project) and must include an allowance for the capital use during COMPARING PROJECT COSTS AND BENEFITS 317 each year. (How the discounted cash flow methodology automatically allows for the return of capital in determining the worth of a project and thus eliminates the need for year-to-year depreciation is illustrated in more detail in the section "What Happened to Depreciation?," below.) We do not deduct interest on the capital supplied by the entity for which we are doing the analysis because in effect the result of a dis- counted cash flow analysis is the allowance for the return to the entity's capital. If we compute net present worth, we are determining what would be left over after allowing for some specified rate of return to the entity's own capital-the interest, if you like. When we compute an internal rate of return, this is the return to the entity's own capital and, in a sense, is the interest which that capital earns. (More precisely, it is the weighted average return to the entity's own capital engaged over the life of the project.) When we calculate the net benefit-investment ratio, we are comparing the present worth of the benefit we expect to gain with the present worth of the investment. Thus, interest is not a cost in deriving the cash flow. Rather, it is the return we assume when we discount to obtain the net present worth or the net benefit-investment ratio and, in the case of internal rate of return, it is the answer we obtain from our calculations. There are two important differences in the manner in which we derive the incremental net benefit when we are carrying out an economic, as opposed to a financial, analysis. The first is that in economic analysis taxes are transfer payments within the society, not payments for re- sources used in production (see chapter 7). Hence, taxes are not deducted as a cost when deriving the incremental net benefit stream as the basis on which to. compute the productivity of capital. To the whole economy, taxes are a part of the "benefit" available to the society as a result of the capital invested in the project, and they may be channeled by the society toward whatever purpose the society decides is best. In contrast, in financial analysis duties and other indirect taxes are a cost that the individual entity must pay before arriving at the amount available to recover its capital and to compensate it for the use of its capital (that is, its incremental net benefit or incremental cash flow). Hence, duties and other indirect taxes are a cost like any other expendi- ture, and they are deducted to arrive at the net benefit before financing. This stream then becomes the remuneration for all resources engaged in the project at market prices, without regard to financing or income taxes. The second important difference in deriving the incremental net bene- fit in economic as opposed to financial analysis is that in financial analy- sis we generally must account for outside capital borrowed by the entity that is undertaking the project-whether the entity is a farmer, an indi- vidual business, or the shareholders of a corporation taken as a group. In financial analysis, when borrowed capital is received it is usually entered in the account as a kind of "benefit" received or "negative cost." Then, when a repayment of principal or a payment of interest is made to the outside supplier of capital, it is deducted from the gross return as a cost in deriving the incremental net benefit or incremental cash flow after 318 MEASURES OF PROJECT WORTH financing. This stream thus becomes the remuneration available for the entity's own capital (its equity) after financing. (Examples may be seen in tables 4-19 and 5-6.) The question of financing does not arise in economic analysis because we assume that all resources employed in the project belong to someone within the society-hence, there are no "outside" suppliers of capital. Also note that, if the entity pays income taxes, these must then be deducted to arrive at the incremental net benefit after financing and taxes, which is the remuneration for the entity's own capital (equity) after financing and taxes. There may be occasions when the analyst would like to look at the return to the society from a project funded by borrowed foreign capital. The kind of economic analysis outlined here is a valid indicator of project worth and will give the correct ranking of projects if the money borrowed from abroad may be used for any of a wide range of projects (or at least if the lender agreed to supply a stipulated amount of money contingent on the borrower's spending the money on a particular project selected by joint agreement from a wide range of alternatives). But if a foreign creditor is only prepared to lend for one particular project that it has stipulated in advance, then the project analyst may want to determine the return to the society's own capital from participation in the project. He can do this by treating the society as a kind of corporate entity in which the citizens are the shareholders and by determining the net benefit after financing, from which he can calculate the return to the society's own capital. Although the incremental net benefit stream as it is derived for project analysis has by convention been called the cash flow, it may include noncash elements. In economic analysis of agricultural projects, the most important of these noncash items are the values of home-consumed production and of wages in kind. These might appear in a settlement project, for example, in which unemployed agricultural laborers are established on small holdings. One cost they might incur would be wages paid in kind. Furthermore, because the settlers could now earn a good living, their income would be considerably above the opportunity cost of their labor. If this is so, the excess value of the home-consumed produc- tion over and above the opportunity cost of their labor would represent not a cost of production but an incremental benefit available to remuner- ate capital and would be included in the cash flow. This would be true even if a settler's family were to eat its entire production (we say nothing in economic analysis based on efficiency prices about who actually re- ceives the incremental net benefit; this point was taken up in more detail in chapters 1 and 7). It is worth repeating a point made earlier. If cost, including investment cost, is subtracted from benefit during the early years of a project, the result will likely be a negative figure-that is, investment cost and initial operating cost will be larger than the benefit. The project will then have a negative incremental net benefit stream or incremental cash flow. The technical term "negative benefit" may take a bit of getting used to, but it really causes no trouble. COMPARING PROJECT COSTS AND BENEFITS 319 Perhaps the tabulation in figure 9-1 and the examples in tables 9-7 and 9-8 (table 9-8 shows the separate income statements for the income taxes reported in table 9-7) can make the derivation of the incremental net benefit or cash flow clearer. The reader may also wish to review the discussions about how to derive the incremental net benefit from farm budgets (chapter 4) and from processing industry accounts (chapter 5). Net Present Worth The most straightforward discounted cash flow measure of project worth is the net present worth (often abbreviated as NPW). This is simply the present worth of the incremental net benefit or incremental cash flow stream. (For a more formal mathematical statement, see the appendix to this chapter.) The net present worth may also be computed by finding the difference between the present worth of the benefit stream less the pres- ent worth of the cost stream, with both cost and benefit defined as in the previous section on deriving the incremental net benefit. This, however, requires somewhat more calculation. Net present worth may be interpreted as the present worth of the income stream generated by an investment. In financial analysis, it is the present worth of the income stream accruing to the individual or entity from whose point of view the analysis is being undertaken-say, the farm family or the processing firm. In economic analysis, it is the present worth of the incremental national income generated by the investment. Economists are somewhat inconsistent in their terminology for this measure. It is often referred to as the net present value (or NPv). In this book we will refer to it as the net present worth to emphasize the parallel with the discounting technique. To calculate the net present worth requires determination of the appropriate discount rate along the lines discussed in the previous sec- tion (the subsection "Choosing the discount rate"). We may illustrate computation of the net present worth by referring to the costs and benefits of the Philippine Ilocos Irrigation Systems Im- provement Project summarized in tables 9-9 and 9-10. (I have slightly modified the figures to make the computations come out even.) A group of improvements is to be made in several irrigation systems in the Ilocos region of northern Luzon. An investment totaling the equiva- lent of US$18.09 million is to be made over a period of five years. After that, there is an annual operation and maintenance cost equivalent to US$0.34 million. The benefit arises from increased crop production. We will carry out the analysis assuming a project life of 30 years. (There is little reason to carry it out any further; we will return to this point in the section on "Length of the Project Period," below.) In table 9-9, the present worth of the gross cost stream discounted at 12 percent is found to be US$20.06 million. Similarly, the present worth of the incremental production stream at 12 percent is found to be US$29.64 million. Subtracting the present worth of the cost stream from the pres- ent worth of the benefit stream gives a difference of US$9.58 million, Figure 9-1. Elements of Net Benefit From the standpoint of financial analysis (all prices are market prices including taxes and subsidies) Capital equipment and buildings Cash operating expenses for goods sold Cash sales (net of or consumed Net benefit before sales taxes) Fertilizer financing Credit sales (net of Electricity (remuneration for sales taxes) - Maintenance supplies - all resources Price of home-consumed Wages engaged, including production Social security return of capital and Subsidies Wages in kind return to capital) Selling, general, and administrative expenses Salaries Bonuses Net benefit after Consulting fees financing Insurance Net financing [remuneration for Change in inventories Loans received (+) entity s own capital Raw materials Debt service (equity) before income Finished goods + Repayment of - taxes, including Duties and other principal (-) return of entity's own indirect taxes Interest (-) capital (equity) and Accounts receivable (-) return to entity's own Accounts payable (+) capital (equity) before taxes] Net benefit after financing and taxes [remuneration for - Income taxes-= entity's own capital (equity) after financing and taxes, including return of entity's own capital (equity) and return to entity's own capital (equity) after taxes] From the standpoint of economic analysis (some values may be shadow prices): Capital equipment and buildings Operating expenses for Value of output goods sold or Net benefit sold consumed, including (remuneration Value of home-consumed wages in kind for all society's production Selling, general, and resources engaged, administrative including return expenses of capital and Change in inventories return to capital) Table 9-7. Derivation of Incremental Net Benefit (currency units) Financial account Economic account' Using shadow exchange rate Ustng standard conversion factor Without With prolect Without With project Without With project Item project Year 1 Yearx Year z project Year 1 Yearx Year z project Year 1 Yearx Year z Value of outputb Inflow (gross benefit) Revenue' Cash sales 1,000 1,000 3,000 3,000 1,200 1,200 3,600 3,600 1,000 1,000 3,000 3,000 Credit sales 100 100 300 300 120 120 360 360 100 100 300 300 Home-consumed production 200 200 300 300 240 240 360 360 200 200 300 300 Off-farm income" 200 0 0 0 100 0 0 0 83 0 0 0 Subsidies' 50 50 125 125 Omit' Omit Omit Omit Omit Omit Omit Omit Total inflow 1,550 1,350 3,725 3,725 1,660 1,560 4,320 4,320 1,383 1,300 3,600 3,600 Cash operating expenses Outflow (gross cost) Goods and services other than labor Fertilizer 50 100 300 300 60 120 360 360 50 100 300 300 Electricity" 50 50 100 100 56 56 112 112 47 47 93 93 Maintenance supplies' 200 300 550 550 220 330 605 605 183 275 504 504 Remuneration for labor (except that belonging to owners of the entity) Wages' 100 150 200 200 50 75 100 100 42 62 83 83 Social security" 15 22 30 30 Omit Omit Omit Omit Omit Omit Omit Omit Payment in kind' 25 40 60 60 12 20 30 30 10 17 25 25 Selling, general, and administrative expenses Salaries 10 20 20 20 10 20 20 20 8 17 17 17 Bonuses 0 0 0 0 0 0 0 0 0 0 0 0 Consulting and management fees 0 0 0 0 0 0 0 0 0 0 0 0 Insurance 10 15 15 15 10 15 15 15 8 12 12 12 Training and research 0 0 0 0 0 0 0 0 0 0 0 0 Duties and indirect taxesm 0 100 0 0 Omit Omit Omit Omit Omit Omit Omit Omit Increase (decrease) in gross fixed assets Capital equipmentn 0 2,000 0 ( 180) 0 2,400 0 ( 216) 0 2,000 0 ( 180) Site improvemento 0 100 0 0 0 100 0 0 0 83 0 0 Increase (decrease) in inventories Raw materialsP 0 100 100 ( 200) 0 120 120 ( 240) 0 100 100 ( 200) Finished goods" 0 250 300 ( 550) 0 300 360 ( 660) 0 250 300 ( 550) Total outflow 460 3,247 1,675 345 418 3,556 1,722 126 348 2,963 1,434 104 Net benefit before financing Total 1,090 (1,897) 2,050 3,380 1,242 (1,996) 2,598 4,194 1,035 (1,663) 2,166 3,496 Incremental - (2,987) 960 2,290 - (3,238) 1,356 2,952 - (2,698) 1,131 2,461 Financing Long-term loans received 0 1,000 0 0 Omit Omit Omit Omit Omit Omit Omit Omit Increase (decrease) in short-term loans 0 0 0 0 Omit Omit Omit Omit Omit Omit Omit Omit Interest received 0 0 0 0 Omit Omit Omit Omit Omit Omit Omit Omit Increase (decrease) in accounts payable and other short-term liabilities 0 60 60 ( 120) Omit Omit Omit Omit Omit Omit Omit Omit Repayment of long-term loansq 0 0 ( 46) 0 Omit Omit Omit Omit Omit Omit Omit Omit Interest paymentsq 0 0 ( 115) 0 Omit Omit Omit Omit Omit Omit Omit Omit Loan commitment fees 0 0 0 0 Omit Omit Omit Omit Omit Omit Omit Omit Decrease (increase) in accounts receivable 0 ( 10) ( 10) 20 Omit Omit Omit Omit Omit Omit Omit Omit Decrease (increase) in other short-term assets except cash 0 0 0 0 Omit Omit Omit Omit Omit Omit Omit Omit Net financing 0 1,050 ( 111) ( 100) Omit Omit Omit Omit Omit Omit Omit Omit Net benefit after financing Total 1,090 ( 847) 1,939 3,280 Omit Omit Omit Omit Omit Omit Omit Omit Incremental - (1,937) 849 2,190 Omit Omit Omit Omit Omit Omit Omit Omit Income taxation Income taxes paid' 286 77 758 804 Omit Omit Omit Omit Omit Omit Omit Omit Net benefit after financing and taxes Total 804 ( 924) 1,181 2,476 Omit Omit Omit Omit Omit Omit Omit Omit Incremental - (1,728) 377 1,672 Omit Omit Omit Omit Omit Omit Omit Omit (Table notes on the following pages.) 324 MEASURES OF PROJECT WORTH (Notes to Table 9-7) Note: The figures in this table are illustrative and do not represent any real entity. They are assumed to be denominated in local currency. Year I is the first year of the project, year x is the first full year of operation, and year z is the terminal year of the project. The table follows the general format of table 5-6, which may also be consulted. Here and in table 9-8, the accounting convention of indicating negative numbers by parentheses has been adopted. a. For a discussion of the principles of economic valuation, see chapter 7. The foreign exchange premium is assumed to be 20 percent. Thus, when using the shadow exchange rate to obtain economic values, the financial price of all traded items is multiplied by I plus the foreign exchange premium stated in decimal terms, or 1.2 (1 + 0.2 = 1 2). When using the conversion factor to obtain economic values, the financial price of all nontraded items is multiplied by a standard conversion factor of 0.833 (1 -- 1.2 = 0.833). b. All output is assumed to be of tradable items. c. Sales are shown net of sales discounts and returned goods and net of sales taxes. Credit sales are treated as a real resource use because it is assumed that the output has been consumed. d. Off-farm income is included to account correctly for the benefit forgone in giving up off-farm income to participate in the project. Although especially applicable to farm accounts, a comparable entry might be included for small firms, in which event salaries would apply only to salaried employees In the economic account, the off-farm income is assumed to come from unskilled labor services provided by the family and thus to have the same value as hired farm labor; it is shadow-priced at half the market value (see note k). e. These are direct subsidies. When indirect subsidies operate to change the market prices of items, the financial prices are adjusted to economic values according to the procedures for valuing traded or nontraded items as appropriate. f. Items marked "Omit" are included in calculating the financial incremental net benefit (incremental cash flow), but they are not included when calculating the economic in- cremental net benefit. g. Fertilizer is assumed to be entirely a traded item, although application costs would no doubt require expenditure for nor.traded items h. For electricity, it is assumed that 60 percent of the value arises from traded sources such as oil and generating equipment and that 40 percent arises from nontraded sources such as labor and local construction materials. Thus, when the shadow exchange rate is used, 60 percent of the value of electricity is treated as a traded item and is multiplied by I plus the foreign exchange premium stated in decimal terms, and 40 percent of the value of electricity is treated as a nontraded item and is carried to the economic account unchanged to obtain the economic value of electricity of56 in the without-project situation [I + 0.2 = 1.2; (50 x 0.6 x 1.2) + (50 x 0.4) = 56]. Similarly, when the conversion factor is used, 60 percent of the value of electricity is treated as a traded item and is carried to the economic account unchanged, and 40 percent of the value of electricity is treated as a nontraded item and is multiplied by the standard conversion factor of 1 divided by I plus the foreign exchange premium stated in decimal terms to obtain the economic value of electricity of47 in the without-project situation [I - (1 + 0 2) = 0.833; (50 x 0.6) + (50 x 0.4 x 0.833) = 47]. i. Maintenance supplies are assumed to be half traded and half nontraded. A valuation method parallel to that outlined for electricity in note i is followed. Thus, when the shadow exchange rate is used, the economic value in the without-project situation is 220 [(200 x 0.5 x 1.2) + (200 x 0.5) = 220]. When the conversion factor is used, the economic value in the without-project situation is 183 [(200 x 0.5) + (200 x 0.5 x 0.833) = 183]. For conve- nience, maintenance supplies are shown only as a cash operating expense, although in practice some maintenance would also be included among the selling, general, and ad- ministrative expenses j. The shadow wage rate is assumed to be half the market wage. Thus, when the shadow exchange rate is used, the market wage used in the financial analysis is multiplied by 0.5 to obtain the economic wage of 50 in the without-project situation (100 x 0.5 - 50) When the conversion factor approach is used, the market wage used in the financial analysis is first multiplied by 0.5 and then multiplied by the standard conversion factor to obtain the economic wage of 42 in the without-project situation (100 x 0 5 x 0.833 = 42) (Table notes continue on the followng page.) COMPARING PROJECT COSTS AND BENEFITS 325 Table 9-8. Income Statements for Income Taxes Reported in Table 9-7 (currency units) With project Without- project Year I Year x Year z Revenue-sales 1,100 1,100 3,300 3,300 Total revenue 1,100 1,100 3,300 3,300 Cash operating expenses 415 622 1,180 1,180 Selling, general, and administrative expenses 20 35 35 35 Noncash operating expenses- depreciationa - 200 200 200 Total operating expenses 435 857 1,415 1,415 Nonoperating income and expenses Interest paid 0 0 115 0 Duties and indirect taxes 0 100 0 0 Subsidies ( 50) ( 50) ( 125) ( 125) Total nonoperating expenses ( 50) 50 ( 10) ( 125) Income (profit) before income taxes 715 193 1,895 2,010 Income taxes 286 77 758 804 Net income (profit) after taxes 429 116 1,137 1,206 Note: Income taxes are assumed to be 40 percent of income (profit) before taxes. The format here follows that of table 5-2. a. Depreciation is allocated on a ten-year, straight-line basis and is charged only on an investment of 2,000. k. Social security is considered to be a direct transfer payment and is omitted from the economic account. 1. Since payment in kind is a form of labor cost, it should be shadow-priced to reflect the opportunity cost of labor. This would mean shadow-pricing the payment in kind in the same manner as for the money wage, in this case at half the financial wage. Since it is the opportunity cost that determines the shadow wage rate, the method of valuing the payment in kind would remain the same even if the payment in kind were made in a tradable commodity such as food grain. m. Recall that sales are shown net of sales taxes. If this were not the case, there would be an entry for sales taxes received and for sales taxes remitted to the government in the financial account, but these entries would be a direct transfer and thus would not be included in the economic account. Often capital equipment is shown inclusive of duties in financial accounts. If this is the case, duties would be deducted before calculating the economic value and would not appear as a separate entry in the economic accounts. n. Capital equipment is assumed to be net of duties (which are shown separately) and to consist entirely of traded items, although installation costs would no doubt require expen- diture for nontraded items. In year z, the negative entry for the capital equipment repre- sents the residual value. o. Assumed to involve only nontraded items. p. Assumed to be entirely traded items. q. The debt service payments are calculated for the second year of a twelve-year loan of 1,000 at 12 percent interest assuming a constant payment of 161 a year. r. Income taxes are assumed to be 40 percent of income (profit) before taxes. The pro forma income statements are given in table 9-8 following the format of table 5-2. The depreciation is allocated on a ten-year, straight-line basis and is charged only on an investment of 2,000. Table 9-9. Computation of Net Present Worth Subtracting the Present Worth of the Gross Incremental Cost from the Present Worth of the Value of Incremental Production, Ilocos Irrigation Systems Improvement Project, Philippines (millions of US$) Incremental cost Value of Operation Discount Present incremental Discount Present Capital and Produc- factor worth production factor worth Year items maintenance tion Gross 12% 12% (gross benefit) 12% 12% 1 1.09 0 0 1.09 0.893 0.97 0 0.893 0 2 4.83 0 0 4.83 0.797 3.85 0 0.797 0 3 5.68 0 0 5.68 0.712 4.04 0 0.712 0 4 4.50 0 0 4.50 0.636 2.86 0 0.636 0 5 1.99 0 0 1 99 0.567 1.13 0 0.567 0 6 0 0.34 0.33 0.67 0.507 0.34 1.67 0 507 0.85 7 0 0.34 0.63 0.97 0.452 0.44 3.34 0.452 1.51 8 0 0.34 0 96 1.30 0.404 0.53 5.00 0.404 2.02 9 0 034 1.28 1.62 0.361 0.58 6.68 0.361 2.41 10-30 0 0.34' 1.61" 1.95' 2.727b 5.32 8.38" 2.727b 22.85 Total 1809 8.50 37.01 63.60 8 056 2006 192.67 8.056 29.64 Net present worth at 12 percent = US$29.64 - US$20 06 = US$+ 9.58 US$ U.S dollars. a. Annual amount for years 10 through 30 inclusive. To reach column total, Source: Adapted from World Bank, "Philippines: Appraisal of the National this amount must be included 21 times. Irrigation Systems Improvement Project: 1," 1488a (Washington, D.C., 1977; b. Present worth of an annuity factor for years 10 through 30 inclusive. See restricted circulation), annex 20, tables 2 and 6. the subsection on "Present worth of a stream of future income" for method of computation. COMPARING PROJECT COSIS AND BENEFITS 327 which is the net present worth at a 12 percent discount rate (29.64 - 20.06 = 9.58). Two points about the layout of tables 9-9 and 9-10 and the computation should be noted. Opposite the entry for the tenth through the thirtieth years, the annual amount is entered in the undiscounted cost and benefit columns. To reach the undiscounted total in these columns, the annual amount must be included for each year from the tenth through the thirtieth years, or 21 times. But the present worth entered in the line for the tenth to the thirtieth years is not an annual amount; rather, it is the total present worth of the stream for the whole twenty-one-year period. This convention for table layout is followed throughout chapters 9 and 10. Note, too, that the total of the discount factors cannot be taken and multiplied by the total of the cost or benefit stream to obtain the present worth. In the gross cost stream in table 9-9, for example, the present worth of US$20.06 million cannot be reached by multiplying the undis- counted total of the gross cost, US$63.60 million, by the total of the discount factors, 8.056 (63.60 x 8.056 4 20.06). The year-by-year proce- dure must be followed. Including the total of the present worth factors in the tables serves only as an internal check. The analyst knows he has determined the factors correctly if they add to the present worth of an annuity factor for the final year of the project. Although the net present worth may be computed by subtracting the total discounted present worth of the cost stream from that of the benefit stream, it is easier and usual practice to compute it by discounting the incremental net benefit stream or incremental cash flow. Table 9-10 illustrates how this works in the case of the Philippine irrigation exam- ple. The gross incremental cost in each year is subtracted from the value of incremental production to obtain the incremental net benefit, or cash flow. Thus, in year 1 the gross incremental cost is US$1.09 million, and there is no incremental production, so the incremental net benefit or cash flow is US$- 1.09 million (0 - 1.09 = -1.09). As another example, in year 7 the gross incremental cost is US$0.97 million, and the value of incremental production is US$3.34 million, so the incremental net bene- fit or cash flow is US$+ 2.37 million (3.34 - 0.97 = 2.37). Summing the present worths of the incremental net benefit stream, or cash flow, gives us a value of US$+9.58 million. This is exactly the same amount we obtained when we subtracted the present worth of the gross incremental cost from the present worth of the value of incremental production in table 9-9. Deriving the incremental net benefit, or cash flow, first and then discounting, however, is the simpler computational procedure. A considerable advantage of discounted cash flow measures such as the net present worth, the internal rate of return, or the net benefit- investment ratio is that it makes no difference at all at what point in the computation the netting out takes place. To obtain the incremental net benefit, the analyst may subtract gross cost from gross benefit, the invest- ment cost from the net benefit, or follow any other computational pattern that suits the analyst's analytical needs-provided only that double counting is avoided. In contrast, for the benefit-cost ratio discussed later Table 9-10. Computation of Net Present Worth Discounting the Incremental Net Benefit Stream (Cash Flow), Ilocos Project (millions of US$) Incremental cost Value of incremental Operation production Incremental Discount Present Capital and Produc- (gross net benefit factor worth Year items maintenance tion Gross benefit) (cash flow) 12% 12% 1 1.09 0 0 1.09 0 - 1.09 0.893 - 0.97 2 4.83 0 0 4.83 0 - 4.83 0.797 - 3.85 3 568 0 0 5.68 0 - 5.68 0.712 - 4.04 0C 4 4.50 0 0 4.50 0 - 4.50 0.636 - 2.86 5 1.99 0 0 1.99 0 - 1.99 0.567 - 1 13 6 0 0.34 033 067 1.67 + 1.00 0.507 + 0.51 7 0 0.34 0.63 0.97 3.34 + 2.37 0.452 + 1.07 8 0 0.34 0.96 1.30 5.00 + 3.70 0.404 + 1.49 9 0 0.34 1.28 1.62 6.68 + 5.06 0.361 + 1.83 10-30 0 0.34" 1.61' 1.95' 8.38a + 643a 2 727b + 17.53 Total 18.09 8.50 37.01 63.60 192.67 + 129.07 8.056 + 9.58 Net present worth at 12 percent = US$ +-9.58 Source: Same as table 9-9. b Present worth of an annuity factor for years 10 through 30 inclusive. See a Annual amount for years 10 through 30 inclusive. To reach column total, the subsection on "Present worth of a stream of future income" for method of this amount must be included 21 times. computation. COMPARING PROJECT COSTS AND BENEFITS 329 in this chapter, the manner in which costs and benefits are netted out makes a difference in the ratio value. (We will show a numerical illustra- tion of this in the section on the benefit-cost ratio, below.) Suppose the net present worth had worked out to be negative? Then we would have a case in which, at the discount rate assumed, the present worth of the benefit stream is less than the present worth of the cost stream-that is, insufficient to recover investment. It would be better to put the money in a bank at the assumed interest rate (or, more likely, to invest it in a better project) than to invest it in the project analyzed. The formal selection criterion for the net present worth measure of project worth is to accept all independent projects with a zero or greater net present worth when discounted at the opportunity cost of capital. (Independent projects are those which are not mutually exclusive; that is, projects of a kind that implementing one necessarily precludes im- plementing another.) An obvious problem of the net present worth mea- sure is that the selection criterion cannot be applied unless there is a relatively satisfactory estimate of the opportunity cost of capital. No ranking of acceptable, alternative independent projects is possible with the net present worth criterion because it is an absolute, not rela- tive, measure. A small, highly attractive project may have a smaller net present worth than a large, marginally acceptable project. As long as both have a positive net present worth and the administrative capacity and resources exist to implement both (and the projects are not mutually exclusive), this difference is not important. Our selection criterion tells us to undertake both, since there will be enough money if the opportunity cost of capital has been correctly estimated. If because of lack of funds or administrative resources we cannot undertake both, the implication is that the opportunity cost of capital has been estimated to be too low. Then the correct response is to raise the estimate until we have only the selection of projects with net present worths that are zero or positive and for which, in fact, there will be just sufficient investment funds. Net present worth is also the preferred selection criterion to choose among mutually exclusive projects because of a possible error in ap- plying the internal rate of return measure to such projects (see chapter 10, the section on "Choosing among Mutually Exclusive Alternatives"). Internal Rate of Return Another way of using the incremental net benefit stream or in- cremental cash flow for measuring the worth of a project is to find the discount rate that makes the net present worth of the incremental net benefit stream or incremental cash flow equal zero. This discount rate is called the internal rate of return. It is the maximum interest that a project could pay for the resources used if the project is to recover its investment and operating costs and still break even. It is the "rate of return on capital outstanding per period while it is invested in the Table 9-11. Computation of Internal Rate of Return, Ilocos Project (millions of US$) Incremental cost Value of incremental Operation Discount Present production Present Incremental Present Capital and Produc- factor worth (gross worth net benefit worth Year items maintenance tton Gross 18% 18% benefit) 18% (cash flow) 18% (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) 1 1.09 0 0 1.09 0.847 0.92 0 0 - 1.09 -0.92 2 4.83 0 0 4.83 0.718 3.47 0 0 - 4.83 -3.47 3 5.68 0 0 5.68 0.609 3.46 0 0 - 5.68 -3.46 4 4.50 0 0 4.50 0.516 2.32 0 0 - 4.50 -232 5 1.99 0 0 1.99 0.437 0.87 0 0 - 1.99 -0.87 6 0 0.34 0.33 0.67 0.370 0.25 1.67 0.62 + 1.00 +0.37 7 0 0.34 0.63 0.97 0.314 0.30 3.34 1.05 + 2.37 +0.74 8 0 0.34 0.96 1.30 0.266 035 5.00 1.33 + 3.70 +0.98 9 0 0.34 1.28 1.62 0.225 0.36 6.68 1 50 + 5.06 + 1.14 10-30 0 0.34" 1.61P 1.95a 1.214b 2.37 8 38" 10.17 + 6.43a +7.81 Total 18.09 8.50 37.01 63.60 5.516 14.67 192.67 14.67 + 129.07 0 Net present worth at 18 percent = US$14.67 - US$14.67 = US$0 Internal rate of return = 18 percent Source- Same as table 9-9. b. Present worth of an annuity factor for years 10 through 30 inclusive. See a. Annual amount for years 10 through 30 inclusive. To reach column total, the subsection "Present worth of a stream of future income" for method of this amount must be included 21 times. computation. COMPARING PROJECI COSTS AND BENEFITS 331 project" (Merrett and Sykes 1963, p. 38). (For a more formal mathemati- cal statement, see the appendix to this chapter.) The internal rate of return is a very useful measure of project worth. It is the measure the World Bank uses for practically all its economic and financial analyses of projects and the measure used by most other inter- national financing agencies. To avoid confusion between use of the internal rate of return in finan- cial analysis and use of the same techniques in economic analysis, we will adopt a distinguishing terminology. When the internal rate of return is used in financial analysis, we will refer to the result as the "financial rate of return"; when it is used in economic analysis, we will call the result the "economic rate of return." When the emphasis of our discussion is on methodology, however, we will refer simply to the internal rate of return. To see how the internal rate of return is calculated, we may take another look at the Philippine Ilocos Irrigation Systems Improvement example for which we derived the incremental net benefit (or in- cremental cash flow) in table 9-10. But this time, instead of discounting at 12 percent, let us discount at 18 percent, as shown in table 9-11, column 11. By selecting the 18 percent discount rate, we have driven the net present worth of the project down to zero. Put another way, at a discount rate of 18 percent, this project just breaks even-that is, it could earn back all the capital and operating costs expended on it and pay 18 percent for the use of the money in the meantime. From yet another vantage point, we could have asked ourselves what interest rate this project would earn. In other words, what would be the earning of the money invested in this project? This earning rate of a project is the internal rate of return. The formal selection criterion for the internal rate of return measure of project worth is to accept all independent projects having an internal rate of return equal to or greater than the opportunity cost of capital. One word of caution, however. In the case of mutually exclusive proj- ects, direct comparison of internal rates of return can lead to an erroneous investment choice. This danger can be avoided most easily by using the net present worth criterion, but it can also be avoided by discounting the differences in the cash flows of alternative projects. (See chapter 10, the section on "Choosing among Mutually Exclusive Alternatives".) Note that an internal rate of return of a series of values such as a cash flow can exist only when at least one value is negative. If all the values are positive, no discount rate can make the net present worth of the stream equal zero. No matter how high the discount rate, the net present worth of a series would have to be positive if it includes no negative number. Although the internal rates of return of different projects will vary, projects cannot with confidence be ranked on the basis of the internal rate of return. Only in a very general way will the internal rate of return tell us that one project is better than another, in the sense that it contrib- utes more to national income relative to the resources used. A project with a 25 percent economic rate of return is likely to be a better invest- 332 MEASURES OF PROJECT WORTH ment than a project with a 15 percent economic rate of return, but this is at best a rough approximation. To be more precise, we must refer to our formal decision criterion. If the opportunity cost of capital is correctly estimated at 12 percent, we would accept both the 15 percent project and the 25 percent project. If we have to choose between them because of a limitation of funds or administrative resources, then we should raise the estimate of the opportunity cost of capital until the cut-off rate for the internal rate of return is such that all projects with an internal rate of return greater than the cut-off can be implemented. If we were to raise the cut-off rate in the example above to 18 percent, then the project with a 15 percent economic rate of return would drop out of the investment program. But as long as the estimate of the opportunity cost of capital- hence, the cut-off rate-remains at 12 percent, we cannot know with certainty that the project with 25 percent return contributes relatively more to national income than the one with 15 percent return, and we cannot say with confidence that we should implement the project with the 25 percent rate of return first. Computing the internal rate of return Except by lucky accident, one cannot simply choose that discount rate which will make the incremental net benefit stream equal to zero, as was arranged for illustrative purposes in table 9-11. Unhappily, there is no formula for finding the internal rate of return. We are forced to resort to a systematic procedure of trial and error to find that discount rate which will make the net present worth of the incremental net benefit stream equal zero. The most difficult aspect of the trial and error is making the initial estimate. If the estimate is too far from the final result, then several trials will have to be made to find two rates close enough together to permit accurate interpolation (interpolation is the process of finding a desired value between two other values). A quick approximation of the discount rate at which to begin the computation may be made by using table 9-12. The variables we must know are: (1) the number of years the incremental net benefit stream (cash flow) is negative; (2) the number of years the incremental net benefit stream (cash flow) is positive; (3) the annual average incremental net benefit (cash flow) for those years when the stream is positive; and (4) the total of the incremental net benefit (cash flow) for those years when the stream is negative (the negative sign of the sum is ignored). To illustrate the use of table 9-12, let us again refer to the Philippine irrigation improvement example (table 9-11). Looking at the in- cremental net benefit stream (cash flow) in column 10, we can see that the incremental net benefit stream is negative during five years. The total incremental net benefit for those years when the stream is positive is US$147.16 million (recall that the annual incremental net benefit of US$6.43 million for years 10 through 30 must be included 21 times.) The annual average incremental net benefit for those years when the stream COMPARING PROJECT COSTS AND BENEFITS 333 Table 9-12. Method of Computing Initial Estimate of Internal Rate of Return First, Second, determine: determine: Third, divide: Average annual positive incremental net benefit Total negative incremental net benefit Number Number and use the result to select the proper column here. of years of years Then find the initial estimate opposite the appro- incremental incremental priate number of years for the negative and the net benefit net benefit positive incremental net benefit streams. stream is stream is negative positive 0.1 0.2 0.3 0.4 0.5 0.6 0.8 1.0 5 - 0 12 22 30 38 >50 >50 1 10 0 12 21 28 34 40 50 >50 20 7 16 23 28 34 38 47 >50 5 - 0 10 19 25 30 40 49 2 10 0 11 18 24 29 34 42 48 20 6 14 20 25 29 33 40 46 5 - 0 9 15 21 25 33 40 3 10 0 10 16 21 26 29 36 41 20 6 13 18 23 26 29 35 40 5 - 0 7 13 18 22 28 34 4 10 0 9 15 19 23 26 31 36 20 6 12 17 21 24 26 31 35 5 - 0 7 12 16 19 25 29 5 10 0 8 13 17 21 23 28 32 20 5 12 16 19 22 24 28 31 This table assumes standardized in- +60- cremental net benefit streams with this general time profile: +40- z +20- r.0- M1i l S20n Years 0 - 20- - 40- Source: Adapted from Schaefer-Kehnert (1979). is positive is thus US$5.89 million (147.16 + 25 = 5.89). The total of the incremental net benefit in those years when the stream is negative is US$ - 18.09 million. We will ignore the sign and take the sum to be simply US$18.09 million. Dividing the annual average positive in- cremental net benefit by the total negative incremental net benefit gives us 0.33 (5.89 -- 18.09 = 0.33). In table 9-12 we can find the group of figures opposite the entry for a negative period of five years and for a positive period of twenty years, the Table 9-13. Computation of Internal Rate of Return Illustrating Interpolation, Ilocos Project (millions of US$) Incremental cost Value of incremental Operation production Incremental Discount Present Discount Present Capital and Produc- (gross net benefit factor worth factor worth Year items maintenance tion Gross benefit) (cash flow) 16% 16% 20% 20% 1 1.09 0 0 1.09 0 - 1.09 0862 - 0.94 0.833 -091 2 4.83 0 0 4.83 0 - 483 0.743 - 3.59 0694 -3.35 3 5 68 0 0 5.68 0 - 5.68 0.641 - 3.64 0579 -3.29 4 4.50 0 0 450 0 - 4.50 0.552 - 248 0.482 -2.17 5 1.99 0 0 1.99 0 - 1.99 0476 - 095 0.402 -080 6 0 0.34 0.33 0.67 1 67 + 1.00 0.410 + 0.41 0335 +0.34 7 0 0.34 0.63 0.97 3.34 + 2 37 0.354 + 084 0.279 +066 8 0 0.34 0.96 1.30 500 + 3.70 0305 + 1 13 0233 +0.86 9 0 0.34 1 28 1 62 668 + 5.06 0.263 + 1.33 0.194 +0.98 10-30 0 0 34' 1.61 1 95' 8.38' + 6.431 1 570b + 10.10 0 948" +6.10 Total 18 09 8.50 37.01 63.60 192.67 + 129.07 6.176 + 2 21 4.979 - 1.58 Internal rate of retin (economic rate of return) = 16 + 4[2.21 - (2.21 + 1.58)] = 16 + 4(2.21 - 3.79) = 16 + 4(0.58) = 18.32 = 18 percent Source- Same as table 9-9. b. Present worth of an annuity factor for years 10 through 30 inclusive. See a. Annual amount for years 10 through 30 inclusive. To reach column total, subsection on "Present worth of a stream of future income" for method of this amount must be included 21 times. computation COMPARING PROJECT COSTS AND BENEFITS 335 longest given in the table. In the column under 0.3 we find an initial estimate of the internal rate of return of 16 percent, and under the column for 0.4 an initial estimate of 19 percent. Because our estimate of the annual average positive incremental net benefit divided by the total negative incremental net benefit was 0.33, we must interpolate between 16 and 19 percent. Since 0.33 is three-tenths of the interval between 0.3 and 0.4, we must take three-tenths of the interval between 16 and 19 percent, or about 0.9 percent, and this gives us an initial estimate for the internal rate of return of 16.9 percent, which we would round to the nearest whole percentage point, or 17 percent. (We round at this point because we want to use this estimate for our initial discount rate, and discounting tables most often do not have appropriate fractional dis- count rates.) It is characteristic, as in this example, that our initial estimate of the internal rate of return will be somewhat in error; and, unlike this exam- ple, no whole percentage discount rate will drive the incremental net benefit stream (cash flow) down to exactly zero. Instead, we will have to find a whole percentage discount rate that is somewhat too low and another that is somewhat too high and then interpolate between the two to find our internal rate of return. We may proceed as indicated in table 9-13. We use our initial estimate of the internal rate of return to determine the present worth of the in- cremental net benefit stream. If we were using detailed discounting tables such as Compounding and Discounting Tables for Project Evaluation (Gittinger 1973), we would do our initial discounting at 17 percent. If, however, we wish to use the summary three-place tables in appendix B, we will have to choose between 16 percent and 18 percent to do our initial discounting, since there is no column for 17 percent. Our initial estimate was 16.9 percent, which is closer to 16 percent than to 18 percent, so we choose to do our initial discounting at 16 percent. In this instance, we find the present worth at 16 percent to be US$+2.21 million. When the discounted present worth of the incremental net benefit stream is posi- tive, we know that, at this discount rate, the present worth of the project benefit is greater than the present worth of the cost. The project could pay a higher rate of interest and still recover the resources invested. Hence, we know that 16 percent is too low an estimate of the internal rate of return for this project. Now we need another estimate of the internal rate of return that is on the high side. In practice, it is better never to interpolate between intervals greater than about five percentage points because wider intervals can easily introduce an interpolation error. Five additional percentage points would give us an estimate of the internal rate of return of 21 percent. Since the tables in appendix B contain no entry for 21 percent, if we wish to base our computation on them we must choose either 20 or 22 percent. If we discount at 20 percent, we obtain a present worth for the incremental net benefit stream of US$ - 1.58 mil- lion. When the present worth of the incremental net benefit stream is negative, we know that at that discount rate the present worth of the cost stream is greater than the present worth of the benefit stream. The 336 MEASURES OF PROJECT WORTH project cannot pay such a high rate of interest and still recover the resources invested. Just where does the real internal rate of return lie? We could find out by successively narrowing down our limits until finally we find the discount rate that will make the sum exactly zero, but this would require much repetitive computation and the use of fractional discount factors for which no tables exist. Instead, we use interpolation to estimate the true value. (Again, interpolation is simply finding the intermediate value between two discount rates we have chosen. Many readers may have learned how to interpolate when they studied trigonometry in secondary school; the procedure outlined here is exactly the same.) The rule for interpolating the value of the internal rate of return lying between discount rates too high on the one side and too low on the other is: Present worth of incre- mental net benefit Internal Lower Difference stream (cash flow) at rate of = discount + between the the lower discount rate return rate discount rates Sum of the present worths of the incremental net bene- fit streams (cash flows) at the two discount rates, signs ignored This procedure has been applied at the bottom of table 9-13. The lower discount rate is 16 percent. The difference between the two discount rates is the difference between 16 percent and 20 percent, or 4 percent. The present worth of the incremental net benefit stream at the lower discount rate of 16 percent is US$2.21 million. The present worth at the higher discount rate of 20 percent is US$ - 1.58 million. The sum of the present worths of the streams at the two discount rates, ignoring the signs, is US$3.79 million (2.21 + 1.58 = 3.79). Hence: Internal rate of return = 16 + 4 (2.21 + 3.79) = 16 + 4(0.58) = 18.32 = 18 percent. As noted earlier, it is better not to try interpolation between a spread wider than about five percentage points. The economic or financial rates of return should always be rounded to the nearest whole percentage point, since the underlying projections never can justify the implication of greater precision. Interpolation between discount rates that bracket the true internal rate of return always somewhat overstates the true return. This is so because our linear interpolation technique makes the implicit assump- tion that, as we move from one discount rate to another, the internal rate of return will change following a straight line; actually, the true value of the internal rate of return follows a concave curvilinear function, as indicated in figure 9-2. The error introduced by interpolation is usually COMPARING PROJECT COSTS AND BENEFITS 337 Figure 9-2. Interpolation Error, Jatiluhur Irrigation Project, Indonesia + 1 50 + 1.45 c+ 1.00 - Interpolated value 00 +050 True -0.21 - 0.50 15 16 17 18 19 20 Discount rate (percent) Rp Indonesian rupiahs. Source: Adapted from World Bank, "Djatiluhur Irngation Project," PA-37 (Washington, D.C , 1970, restricted circulation), p.26 and annex 10, p Since this report was submitted, a spelling reform has changed the spelling of the project area to Jatiluhur. slight and disappears when the result is rounded to the nearest whole percentage point. Nevertheless, a final figure for the rate of return should always be verified. This can be done most easily by taking advantage of the fact that the interpolation error becomes less and less as we approach one of the discount rates between which we are interpolating. Thus, a verification procedure that reduces the computational burden is to use the internal rate of return estimated by interpolation to discount the incremental net benefit stream once again. We can then interpolate between our estimated internal rate of return and the lower of the discount rates we previously used. This procedure is illustrated in table 9-14 with reference to the Jatiluhur Irrigation Project in Indonesia. Interpolating between 15 percent and 20 percent gives us an estimated internal rate of return of 19 percent. Discounting the incremental net benefit stream at 19 percent shows the present worth to have a negative value of Rp -0.21 thousand million. (The symbol for Indonesian rupiahs is Rp.) Interpolating again, this time between 15 percent and 19 percent, we find the estimate to be 18.48 percent, which would be rounded to the nearest whole percentage point of 18 percent. Because we know that the interpolation process introduces very little error at this point but nonetheless does slightly overestimate the true rate of return and be- Table 9-14. Computation of Internal Rate of Return Illustrating Interpolation, Jatiluhur Project, Indonesia (thousand millions of Rp) Incremental Discount Present Discount Present Discount Present Discount Present Incremental Incremental net benefit factor worth factor worth factor worth factor worth Year cost benefita (cash flow) 15% 15% 18% 18% 19% 19% 20% 20% 1 0.5 - - 05 0870 -044 0.847 -042 0.840 - 042 0833 -0.42 2 2.1 04 - 17 0756 -129 0718 -122 0706 -120 0694 -118 3 3.7 07 - 30 0658 -1 97 0609 -1.83 0.593 -1 78 0579 -1 74 4 3.7 1 3 - 24 0572 -1 37 0516 -1 24 0499 -1.20 0.482 -1.16 5 2.0 19 - 01 0497 -0.05 0437 -004 0.419 -004 0.402 -004 6 0.5 22 + 1 7 0432 +073 0370 +063 0352 +0.60 0335 +0.57 7-30 0.5b 2.6b + 2 lb 2 782C +584 2 019, +4.24 1.825 +383 1 653' +3.47 Total 245 689 +444 6567 +1 45 5.516 +0 12 5234 -021 4.978 -050 Internal rate of return interpolating between 15 percent and 20 percent: 15 + 5(1.45 - 1 95) = 15 + 5(0 74) = 15 + 3.70 = 18 70 = 19 percent Internal rate of return interpolating between 15 percent and 19 percent 15 + 4(1 45 - 1 66) = 15 + 4(0 87) = 15 + 3.48 = 18 48 = 18 percent Internal rate of return interpolating between 18 percent and 19 percent 18 + (0 12 - 0 33) = 18 + 0 36 = 18.36 = 18 percent Rp Indonesian rupiahs. b Annual amount for years 7 through 30 inclusive To reach column total, Source Same as figure 9-2 this amount must be included 24 times. a Assumes only an improvement in water control, that is, no accompany- c Present worth of an annuity factor for years 7 through 30 inclusive See ing increase in the use of modern inputs. the subsection on "Present worth of a stream of future income" for method of computation COMPARING PROJECT COSTS AND BENEFITS 339 cause we have rounded to the lower whole percentage value, we could confidently stop at this point. For purposes of illustration, however, one further verification is made in table 9-14, by interpolating between 18 and 19 percent. At 18 percent we have a positive present worth, and at 19 percent a negative present worth, so we know that the internal rate of return rounded to the nearest whole percentage point must be either one or the other value. Since the interpolated value between 18 and 19 percent is 18.36 percent, and we know that to be above the true rate by some small amount, we can say with certainty that the internal rate of return rounded to the nearest whole percentage point must be 18 percent. Reinvestment of returns A frequent criticism of the internal rate of return is that there is an implicit assumption that all returns from the project will be reinvested at the internal rate of return. This is not, in fact, the case. Instead, as we have noted, the internal rate of return is correctly interpreted as being "the rate of return on capital outstanding per period while it is invested in the project" (Merrett and Sykes 1963, p. 38). Returns withdrawn from a project may be reinvested at any other rate or consumed without affecting the internal rate of return of the project. In some instances, the reinvestment criticism relates to projects of different duration. If there are two projects, one of ten years' duration that yields 40 percent and another of twenty years' that yields 20 percent, which is preferable? Straight comparison would indicate the higher- yielding alternative for the shorter period. But if it were assumed that there would be no high-yielding project in which to reinvest the funds generated by the project of shorter duration, then it is possible for returns over the whole twenty years to be maximized by investing in the project with lower yield but longer duration. The investment decision in this instance will rest on the analyst's assumption about possible project opportunities ten years hence. The investment decision could be guided by determining the net present worth or internal rate of return of ex- pected costs and returns over the full twenty years, say one twenty-year project versus two ten-year projects. More than one possible internal rate of return Under certain circumstances--exceedingly rare in agricultural proj- ects-it is possible that more than one discount rate will make the present worth of the incremental net benefit stream equal zero. This possibility has been the source of considerable (and generally exagger- ated) criticism of the internal rate of return as a discounted measure of project worth. (No similar problem exists with the other measures of project worth discussed in this chapter.) More than one solution in determining the internal rate of return can exist only when, following a period of positive cash flows sizable enough Table 9-15. Internal Rate of Return Calculation Illustrating Multiple Solutions, Oil Well Project (thousands of US$) Incremental Discount Present Discount Present Discount Present Discount Present net benefit factor worth factor worth factor worth factor worth Year (cash flow) 20% 20% 25% 25% 40% 40% 45% 45% 1-4 + 50 2.589 +129 2.362 +118 1.849 + 92 1.720 + 86 5 -750 0.402 -302 0328 -246 0.186 -140 0 156 -117 6-20 +100 1.879 + 188 1.265 +126 0.462 + 46 0345 + 34 Total +950 4.870 + 15 3.955 - 2 2.497 - 2 2.221 + 3 Source: Grant and Ireson (1964, p. 509). COMPARING PROJECT COSTS AND BENEFITS 341 that the cumulative present worth up to that point is positive, there then occur negative cash flows such that the present worth at to of the cash flow from a given year onward (discounted in the normal way) is nega- tive. Under such circumstances there may be more than one discount rate that will bring the present worth of the cash flow down to zero, although this will not necessarily be the case. Negative incremental net benefits for particular years are sometimes found in agricultural projects. They can arise, for instance, when pumps must be replaced in an irrigation system or at the beginning of a replant- ing cycle in a crops project. Usually, however, the negative incremental net benefit flows late in the project will have to be quite large for there to be multiple solutions. An occasional negative year, or a final year or two of negative incremental net benefits, will almost never give rise to multi- ple solutions. The kind of situation in which there are large negative cash flows after the initial investment phase of the project, although it is rare in agricul- ture, can be found in natural resources projects. To illustrate a multiple solution, we may consider an example of such a natural resources project given by Grant and Ireson (1964, pp. 509-10). Take the case of an oil company that is offered a lease on a group of wells for which the primary oil reserves are close to exhaustion. The major condition of the purchase is that the oil company must agree to undertake the injection of water into the underground reservoir to make possible a secondary recovery at the time the primary reserves are exhausted. The lessor will receive a standard royalty from all oil produced from the property whether from the primary or secondary reserves. No immediate payment from the oil company is required. The company estimates it will realize US$50 thousand a year for five years before exhausting the primary reserves. Then it must expend US$800 thousand for the water-injection project- the large negative cash flow-after which it will realize US$100 thousand a year for the following fifteen years. The internal rate of return calcula- tion for this example is shown in table 9-15. From the standpoint of agricultural project analysis, this is a curiosity of internal rate of return theory that has virtually no practical impor- tance. In fact, I have been unable to find an agricultural example from a real project that illustrates the point, and I would appreciate learning of such an example should the reader find one. If such a case exists in an agricultural project, the analytical problem can be resolved by using either the "extended yield" method or the "auxiliary interest rate" method. A discussion of these methods can be found in Merrett and Sykes (1963, pp. 158-65) and Grant and Ireson (1970, pp. 546-65). Point in time for internal rate of return calculations Internal rate of return calculations can be done from any point in time, and all points will give the same return. In our illustrations we always calculate from to into the future because this simplifies the calculation. But if we chose the end of the project, for example, we could increase by Table 9-16. Benefit-Cost Computation Comparing Gross Benefit with Gross Cost, Ilocos Project (millions of US$) Incremental cost Value of incremental Operation Discount Present production Discount Present Capital and Produc- factor worth (gross factor worth Year items maintenance tion Gross 12% 12% benefit) 12% 12% 1 109 0 0 109 0893 0.97 0 0893 0 2 483 0 0 483 0797 385 0 0797 0 3 5.68 0 0 568 0.712 4.04 0 0712 0 4 4.50 0 0 4.50 0636 286 0 0636 0 5 1 99 0 0 1 99 0.567 1 13 0 0567 0 6 0 034 033 0.67 0507 0.34 1 67 0.507 0.85 7 0 034 0.63 097 0.452 044 334 0452 1 51 8 0 034 0.96 1.30 0404 053 500 0404 2.02 9 0 034 1 28 1 62 0361 058 668 0361 2.41 10-30 0 0.34" 1.61' 1 95, 2.727b 5 32 8.38" 2.727b 2285 Total 18 09 8 50 37.01 63 60 8.056 2006 192 67 8 056 29.64 Benefit-cost ratio at 12 percent = US$29 64 - US$20 06 = 1 48 Net present worth at 12 percent = US$29 64 - US$2006 = US$ + 9.58 Source Same as table 9-9 b Present worth of an annuity factor for years 10 through 30 inclusive. See a Annual amount for years 10 through 30 inclusive. To reach column total, the subsection "Present worth of a stream of future income" for method of this amount must be included 21 times. computation. COMPARING PROJECT COSTS AND BENEFITS 343 compound interest factors all values in the incremental net benefit stream and find the interest rate that just makes the stream equal zero. If we were to designate a point midway through the project period as to, we could increase all values before the time from which we choose to work (say from t-5 to t-) by compound interest factors and draw down all future values (say from t+1 to t+ 14) by using discount factors. Again, we would be looking for that interest rate which makes the value of the incremental net benefit stream at to equal zero. Benefit-Cost Ratio A third discounted measure of project worth is the benefit-cost ratio. This is the ratio obtained when the present worth of the benefit stream is divided by the present worth of the cost stream. (For a more formal mathematical statement, see the appendix to this chapter.) Incidentally, economists are quite inconsistent in their use of benefit- cost ratio. About half the time they say "cost-benefit" ratio. Here, how- ever, I will stick to benefit-cost ratio to emphasize the computation by which the measure is worked out. The benefit-cost ratio is not commonly used in developing countries. This is because the value of the ratio will change depending on where the netting out in the cost and benefit streams occurs. (Further on in this section we will illustrate how this works.) The benefit-cost ratio was the first of the discounted measures of project worth to become well known. It is extensively employed in the United States for water resource proj- ects, although it is now increasingly being replaced by a variation of the net present worth criterion. Many economists in developing countries who have studied in the United States or who are familiar with U.S. practice will know of the benefit-cost measure. By the time discounted measures of project worth began to be applied in developing countries, the discounted cash flow measures of net present worth and internal rate of return had become well known and were being widely used for private investment. Since discounted cash flow measures do not change when different conventions for netting out are used, they are easier to apply and were thus adopted by development economists. We return to the Philippine Ilocos Irrigation Systems Improvement Project analyzed in tables 9-9 through 9-11 to show how the benefit-cost ratio is calculated. In table 9-16, the gross benefit is compared with the gross cost. The present worth of the gross incremental cost stream at 12 percent is found to be US$20.06 million, whereas the present worth of the value of incremental production or gross benefit stream is found to be US$29.64 million. Dividing the present worth of the gross benefit stream by the present worth of the gross cost stream, we find the benefit-cost ratio to be 1.48 (29.64 + 20.06 = 1.48). Had the benefit-cost ratio worked out to be less than 1, then the present worth of the costs at this discount rate would have exceeded the present Table 9-17. Benefit-Cost Computation Comparing Net Benefit with Investment plus Operation and Maintenance Cost, Ilocos Project (millions of US$) Incremental cost Value of incremental Net value Operation Discount Present production Incremental of Discount Present Capital and factor worth (gross production incremental factor worth Year items maintenance Total 12% 12% benefit) cost production 12% 12% 1 1.09 0 1.09 0.893 0.97 0 0 0 0.893 0 2 4.83 0 4.83 0.797 3.85 0 0 0 0.797 0 3 5.68 0 5.68 0.712 404 0 0 0 0.712 0 4 4.50 0 4.50 0.636 2.86 0 0 0 0.636 0 5 1.99 0 1.99 0.567 1.13 0 0 0 0.567 0 6 0 0.34 0.34 0.507 0.17 1.67 0.33 1.34 0.507 0.68 7 0 0.34 0.34 0.452 0.15 3.34 0.63 2.71 0.452 1.22 8 0 0.34 0.34 0404 0 14 5.00 0.96 4.04 0.404 1.63 9 0 0.34 0.34 0.361 0.12 6.68 1.28 5.40 0.361 1.95 10-30 0 0.34' 0.34' 2.727b 0.93' 8.38' 1.61' 6.77a 2.727b 1846 Total 18.09 8 50 26.59 8.056 14.36 192.67 37.01 155.66 8.056 23.94 Benefit-cost ratio at 12 percent = US$23.94 - US$14.36 = 1.67 Net present worth at 12 percent = US$23.94 - US$14.36 = US$+9.58 Source: Same as table 9-9. b. Present worth of an annuity factor for years 10 through 30 inclusive. See a. Annual amount for years 10 through 30 inclusive. To reach column total, the subsection "Present worth of a future stream of income" for method of this amount must be included 21 times. computation. COMPARING PROJECT COSTS AND BENEFITS 345 worth of the benefits, and we would not have recovered our initial expenditure plus the return on our investment from the project. Note that the absolute value of the benefit-cost ratio will vary depend- ing on the interest rate chosen. The higher the interest rate, the smaller the resultant benefit-cost ratio, and, if a high enough rate is chosen, the benefit-cost ratio will be driven down to less than 1. The formal selection criterion for the benefit-cost ratio measure of project worth is to accept all independent projects with a benefit-cost ratio of I or greater when the cost and benefit streams are discounted at the opportunity cost of capital. In the case of mutually exclusive projects, the benefit-cost ratio can lead to an erroneous investment choice. The danger can be avoided most easily by using the net present worth crite- rion for mutually exclusive projects. One convenience of the benefit-cost ratio is that it can be used directly to note how much costs could rise without making the project economi- cally unattractive. In table 9-16, for example, we can tell by inspection that costs could rise by 48 percent before the benefit-cost ratio would be driven down to 1. With a little manipulation-taking the reciprocal of the benefit-cost ratio and subtracting it from 1-we can tell that benefits could fall by 32 percent before the ratio would be driven down to one [1 - (1 + 1.48) = 0.32; 29.64 - (29.64 x 0.32) = 20.16; 20.16 20.06 = 1.00]. In effect, this is a quick means to estimate two "switching values." (A switching value is the amount an element of a project can change before the project becomes an unacceptable investment-see the section de- voted to this topic in chapter 10.) In practice, it is probably more common not to compute the benefit- cost ratio using gross cost and gross benefit, but rather to compare the present worth of the net benefit with the present worth of the investment cost plus the operation and maintenance cost. This reflects U.S. govern- ment practice. More specifically, the ratio is computed by taking the present worth of the gross benefit less "associated" cost and then com- paring it with the present worth of the "project economic cost." The associated cost is "the value of goods and services over and above those included in project costs needed to make the immediate products or services of the project available for use or sale." Project economic cost is "the sum of installation costs; operation, maintenance, and replacement costs; and induced costs." The induced cost is "uncompensated adverse effects caused by the construction and operation" of the project. Table 9-17 illustrates how the benefit-cost ratio may be computed using this convention. (It is assumed there are no induced effects.) You will note one result of computing the benefit-cost ratio using this convention of netting out is to make it larger than when the gross cost is compared to the gross benefit. [The terms cited above, and further details of U.S. government practice, can be found in "Procedures for Evaluation of National Eco- nomic Development Benefits and Costs in Water Resources Planning" (U.S. Government 1979).] We may use tables 9-16 and 9-17 to illustrate the point made earlier about the advantage discounted cash flow measures have with regard to 346 MEASURES O- PROJECT WORTH the netting-out convention. When we changed the -netting-out conven- tion from comparing gross benefit with gross cost in table 9-16 to com- paring the net benefit with investment plus operation and maintenance cost in table 9-17, we found that the benefit-cost ratio increased from 1.48 to 1.67. But the net present worth did not change when we changed the netting-out convention. It remained US$9.58 million in both cases. Although in practice projects with higher benefit-cost ratios are often regarded as being preferable (other things being equal), ranking by benefit-cost ratio can lead to an erroneous investment choice. The bene- fit-cost ratio discriminates against projects with relatively high gross returns and operating costs, even though these may be shown to have a greater wealth-generating capacity than that of alternatives with a higher benefit-cost ratio. McKean (1958, pp. 107-16) discusses this point with illustrative examples. Although different conventions for netting out costs and benefits may have been used for different projects, no matter how the netting out is done the same group of projects will be accepted if the benefit-cost ratio criterion, strictly construed, is used. In other words, the same group of projects will have benefit-cost ratios of 1 or greater. But a different netting-out convention can change the value of the ratio, as we have seen when two alternative conventions were applied to the same project in tables 9-16 and 9-17. These points are proven true by observation. If the present worth of the benefit stream exceeds the present worth of the cost stream, then the benefit-cost ratio will obviously be greater than 1. However, moving a cost from the denominator and subtracting it from the numerator-as we did when we omitted the production cost from the gross cost stream and instead deducted it from the gross benefit stream- will change the ratio value (and perhaps the rank of a project in compari- son with alternatives), although the ratio will, of course, remain greater than 1. When the benefit-cost ratio is used as a criterion for evaluating projects in a country, it is desirable that all analysts working in the country follow a common netting-out convention to derive their cost and benefit streams. If they do, they can greatly reduce the chances of a misleading indication of choice should administrators rank projects by their ratio values (as they have a tendency to do, despite the restrictions of the formal choice criterion). Net Benefit-Investment Ratio We have noted that none of the three discounted measures of project worth we have thus far examined can be relied upon to rank projects. The formal selection rule for each is to accept all projects that meet the criterion-a net present worth of zero or greater at the opportunity cost of capital, an internal rate of return equal to or greater than the oppor- tunity cost of capital, or a benefit-cost ratio of 1 or greater at the oppor- tunity cost of capital. Yet in many instances it is convenient to have a COMPARING PROJECT COSTS AND BENEFITS 347 reliable measure to rank projects to determine the order in which proj- ects should be undertaken. Such a need is common in practice. Decision- makers often ask that projects be ranked, and a need for ranking arises, for example, when the capital budget is not sufficient to implement immediately all projects being considered. If projects could be ranked, then the ones with highest priority could be chosen for implementation. A suitable and very convenient criterion for ranking independent proj- ects (that is, those which are not mutually exclusive) that is reliable in all but the most extreme cases is the net benefit-investment ratio (also called the N/K ratio). This is simply the present worth of the net benefits divided by the present worth of the investment; it is a form of the benefit-cost ratio. (For a more formal mathematical statement, see the appendix to this chapter.) The net benefit-investment ratio has been infrequently used in project analysis, perhaps because it has been common practice to rank projects using the internal rate of return or the benefit-cost ratio. As the limitations of these other discounted measures of project worth for ranking projects become better appreciated, it is probable that the net benefit-investment ratio or some close variant will become more widely used. The net benefit-investment ratio is simple to determine when an in- cremental net benefit, or cash flow, has been calculated for a project. This is so because the net benefit may be taken to be the net present worth of the incremental net benefit stream in those years after the stream has turned positive, and investment may be taken to be the present worth of the incremental net benefit stream in those early years of the project when the stream is negative. Thus, to calculate this measure, simply divide the sum of the present worths after the incremental net benefit stream has turned positive by the sum of the present worths of the negative incremental net benefits in the early years of the project. Our discussion of the net benefit-investment ratio will concentrate on its application. A more extensive and formal discussion can be found in Helmers (1979, pp. 99-117). We may illustrate computation of the net benefit-investment ratio by again referring to the Ilocos irrigation example from the Philippines that we have used to illustrate other discounted measures of project worth. The computation is laid out in table 9-18. The present worth of the incremental net benefit stream at 12 percent after the stream has turned positive is US$22.43 million (0.51 + 1.07 + 1.49 + 1.83 + 17.53 = 22.43). This, then, is the present worth of the net benefit. The present worth of the negative incremental net benefits at 12 percent in the early years of the project, which is the present worth of the investment, is US$12.85 million (0.97 + 3.85 + 4.04 + 2.86 + 1.13 = 12.85). We may ignore the negative signs, since the net benefit-investment ratio is stated as a posi- tive expression. The net benefit-investment ratio thus is 1.75 (22.43 + 12.85 = 1.75). An incremental net benefit stream usually will be negative for the first few years of a project and then turn positive each year thereafter for the remaining life of the project. This is the case, for example, in the Philip- Table 9-18. Net Benefit-Investment (N/K) Ratio Computation, Ilocos Project (millions of US$) Incremental cost Value of incremental Incremental Operation production net Discount Present Capital and Produc- (gross benefit factor worth Year items maintenance tion Gross benefit) (cash flow) 12% 12% 1 1.09 0 0 1.09 0 - 109 0.893 - 0.97 2 4.83 0 0 483 0 - 4.83 0.797 - 3.85 3 5.68 0 0 5.68 0 - 5.68 0.712 - 4.04 4 4.50 0 0 4.50 0 - 4.50 0.636 - 2.86 5 1.99 0 0 1.99 0 - 1.99 0.567 - 1.13 6 0 0.34 0.33 067 1.67 + 1.00 0.507 + 0 51 7 0 0.34 0.63 0.97 3.34 + 2.37 0.452 + 1.07 8 0 0.34 0.96 1.30 5.00 + 3.70 0404 + 1.49 9 0 0.34 1.28 1,62 6.68 + 5.06 0.361 + 1.83 10-30 0 0.34' 1.6[P 1.95"' 8.38" + 6.43" 2.727h + 1753 Total 18.09 8.50 3701 63.60 192.67 + 129.07 8.056 + 9.58 Present worth of net benefits at 12 percent N/K ratto at 12 percent = Present worth of investments at 12 percent Present worth of positive incremental net benefit at 12 percent Present worth of negative incremental net benefit at 12 percent US$0.51 + US$1 07 + US$1.49 + US$1.83 + US$17.53 US$22.43 _ 1.75 US$0.97 + US$3.85 + US$4.04 + US$2.86 + US$1.13 US$12.85 Source: Same as table 9-9. b. Present worth of an annuity factor for years 10 through 30 inclusive. See a. Annual amount for years 10 through 30 inclusive. To reach column total, the subsection on "Present worth of a stream of future income" for method of this amount must be included 21 times, computation. COMPARING PROJECT COSTS AND BENEFITS 349 pine irrigation illustration in table 9-18. It might happen, however, that an investment in the project at some later year would be large enough to turn the incremental net benefit for that year negative. An example might be the year when the pumps are replaced in an irrigation project. This does not affect the means of calculating the net benefit-investment ratio. The net benefit will be the present worth of the incremental net benefit stream after the stream has turned positive, and the negative in- cremental net benefit that occurs later in the project is simply included in the net present worth of the benefit stream-reducing the stream, obviously, below what it would otherwise have been. The reason for calculating the net benefit-investment ratio in this manner is that we are interested in an investment measure that selects projects on the basis of return to investment during the initial phases of a project. An occasional negative incremental net benefit later in the life of a project does not increase the capital needed during the investment phase of the project. The formal selection criterion for the net benefit-investment ratio measure of project worth is to accept all projects with a net benefit- investment ratio of 1 or greater when they are discounted at the oppor- tunity cost of capital-in order, beginning with the largest ratio value and proceeding until available investment funds are exhausted. Selecting independent projects in the order of their net benefit- investment ratio maximizes the return per unit of available investment. This, in turn, maximizes the net present worth of the group of projects chosen, and thus maximizes the income stream that is the objective of the program of project investments. If the net benefit-investment ratio is used to rank projects, some limita- tions should be kept in mind. First and most important, the net benefit- investment ratio can be used to rank mutually exclusive projects only when the net benefit-investment ratios of all projects in the investment program are known. Because in practice this would either be impossible or analytically very complex, it is better practice to select among mutu- ally exclusive projects by using the net present worth criterion. Second, there can be instances when the net benefit-investment ratio can indicate incorrect investment decisions, but they are so extreme that they may be ignored when any real project is under consideration. Finally, the net benefit-investment ratio does not hold if one is undertaking what is called dynamic optimization-optimizing project investment over time. Dynamic optimization, however, requires knowledge of all future budget constraints and investment opportunities and so is not a practical methodology to apply in real project investment decisions. The net benefit-investment ratio is very convenient to use in real-life project investment decisions. It may be used to rank projects in those instances in which, for one reason or another, sufficient funds are not available to implement all projects. It thus satisfies a frequent request of decisionmakers that projects be ranked in the order in which they should be undertaken. It is suitable for use when there is incomplete knowledge of all projects in all periods; when budget constraints will vary in magni- tude in the future; and when it is very difficult or costly to redesign 350 MEASURES OF PROJECT WORTH projects in future periods-for example, to change the height of a dam- conditions that make it impossible to attempt dynamic optimization. In a manner similar to that described for the benefit-cost ratio, the net benefit-investment ratio may be used to make a quick estimate of how much the investment cost could rise without making the project econom- ically unattractive. In table 9-18, for example, we can tell by inspection that the investment cost could rise as much as 75 percent before the net benefit-investment ratio would be driven down to one [(22.43 - 12.85) + 12.85 x 100 = 75; 22.43 + (12.85 x 1.75) = 1.00]. By taking the reciprocal of the net benefit-investment ratio and subtracting it from 1, we can quickly tell that the net benefit could fall by almost 43 percent before the ratio would be driven down to one {[1 - (1 - 1.75)] x 100 = 43; [22.43 - (22.43 x 0.43)] - 12.85 = 0.99 }. Thus, again, we have a quick means of estimating two switching values, which are discussed further in the next chapter. Selecting among Project Alternatives To illustrate how discounted measures of project worth can be applied to help choose among project alternatives, we return to the four hypo- thetical investments in pump irrigation presented at the beginning of this chapter and set out in table 9-1 to illustrate undiscounted measures of project worth. In the analysis laid out in table 9-19, we have calculated the net present worth at a 12 percent discount rate, the internal rate of return, the benefit-cost ratio at a 12 percent discount rate, and the net benefit-investment ratio at a 12 percent discount rate. It is clear that we would reject both projects i and ii at the 12 percent discount rate. We would accept project ii only if our discount rate were 8 percent or lower, when it would have a net present worth of zero or greater, an internal rate of return at or above the cut-off rate, and a net benefit-investment ratio of I or greater. At the 12 percent discount rate we would accept both projects iii and Iv, since both have positive net present worths, internal rates of return above the cut-off rate, and bene- fit-cost and net benefit-investment ratios greater than 1. If, however, our investment funds were limited to some 30 million currency units (and ignoring any problem of the cash flow within year 2), we would have to choose between projects iII and Iv. We can see that, by increasing the discount rate, an unambiguous choice would be made. If we set the discount rate at 15 percent, we would accept only project Iv, which would have a positive net present worth and an internal rate of return just above the cut-off rate. We would have just used all our investment funds, so our selection criterion would be clear. Alternatively, and more simply, we could select project iv on the basis that it has the higher net benefit- investment ratio at a 12 percent discount rate. (Because of the very simplified figures we have used for illustration, the net present worth, the internal rate of return, and the benefit-cost ratio also rank the projects in the same order as would the net benefit-investment ratio and the formal COMPARING PROJECT COSTS AND BENEFITS 351 selection criterion of raising the discount rate. This is only a coincidence. At any given discount rate, we cannot with confidence use the net present worth, or the internal rate of return, or the benefit-cost ratio as ranking measures; our criteria tell us only to accept all projects which meet the selection criteria for these three measures. The net benefit-investment ratio is the only measure of the ones we have discussed that can be used with confidence to rank directly.) What Happened to Depreciation? We may now consider a question that sometimes vexes people who are trying to use discounted measures of project worth. In determining the costs used to calculate discounted measures of project worth, we have not included depreciation. When we discussed the incremental net benefit stream or cash flow, we noted that it was an undifferentiated combination of two things: return of capital (which would include depreciation) and returns paid for the use of capital (such as dividends, profits, and the like)-returns to capital. We did not sub- tract depreciation as a cost. Depreciation does not appear in the gross cost computation for the benefit-cost ratio. Yet net present worth deter- mines if a project can earn more than some stated amount of return to capital, the internal rate of return is a measure of the interest a project can pay, and the net benefit-investment ratio determines if the project will have a net benefit greater than the investment at some stated amount of return to capital. The question is, what happened to deprecia- tion? The easiest way to go about illustrating what happens to depreciation in discounted measures of project worth is to compute the net present worth, the internal rate of return, the benefit-cost ratio, and the net benefit-investment ratio of a hypothetical example such as that shown in table 9-20. In this case, we are analyzing a project that does not exactly lose money, but does not make money either. In other words, its net present worth at zero discount rate is zero, its internal rate of return is zero, its benefit-cost ratio at zero rate of interest is just exactly 1, and the net benefit-investment ratio at a zero discount rate is 1. The question we are concerned with here is, did we get our money back? The answer, obviously, is yes. We spent 1,200 thousand currency units over the five years of the project, and by the end of the fifth year we have received just exactly 1,200 thousand back. So we didn't lose any of our capital, and we recovered all of our other costs. Did we earn anything on this project? Clearly, no. Both the net present worth and the internal rate of return of this project were simply zero, and the benefit-cost and net benefit-investment ratios had to be computed at a zero rate of interest to have them come out to 1. Therefore, return of capital is realized (that is, depreciation is covered and fully accounted for) when the net present worth of the project at a zero discount rate is zero or greater, when the project earns an internal Table 9-19. Ranking of Four Hypothetical Pump Irrigation Projects Using N/K Ratio (thousands of currency units) Value of incremental production Incremental Discount Present Present worth Gross (gross net benefit factor worth calculation at Year cost benefit) (cash flow) 12% 12% internal rate of return Rank Discount Present factor worth Project I 0% 0% 1 30,000 - -30,000 0893 -26,790 1 000 -30,000 2 5,000 20,000 +15,000 0797 +11,955 1000 +15,000 3 5,000 20,000 +15,000 0712 +10,680 1 000 +15,000 4 - - - - - - - Total 40,000 40,000 0 2402 - 4,155 3.000 0 Net present worth at 12 percent = - 4,155,000 Internal rate of return = 0 percent Benefit-cost ratio at 12 percent = 0 880 N/K ratio at 12 percent = 22,635 - 26,790 = 0 84 Discount Present factor worth Project 11 8% 8% 1 30,000 - -30,000 0 893 -26,790 0 926 -27,780 2 5,000 20,000 +15,000 0797 +11,955 0857 +12,855 3 5,000 20,000 +15,000 0.712 +10,680 0.794 +11,910 4 5,000 9,100 + 4,100 0636 + 2,608 0.735 + 3,014 Total 45,000 49,100 + 4,100 3038 - 1,547 3312 - I Net present worth at 12 percent = 1,547,000 Internal rate of return = 8 percent Benefit-cost ratio at 12 percent = 0 96' N/K ratio at 12 percent = 25,243 - 26,790 = 0.94 Discount Present factor worth Project n 14% 14% 1 30,000 - -30,000 0.893 -26,790 0.877 -26,310 2 5,000 7,000 + 2,000 0.797 + 1,594 0.769 + 1,538 3 5,000 19,000 + 14,000 0.712 + 9,968 0.675 + 9,450 4 5,000 31,000 + 26,000 0.636 + 16,536 0.592 + 15,392 Total 45,000 57,000 + 12,000 3.038 + 1,308 2.913 + 70 Net present worth at 12 percent = 1,308,000 Internal rate of return = 14 percent Benefit-cost ratio at 12 percent = 1.03a N/K ratio at 12 percent = 28,098 - 26,790 = 1.05 Discount Present factor worth Project iv 16% 16% 1 30,000 - -30,000 0.893 -26,790 0.862 -25,860 2 5,000 7,000 + 2,000 0.797 + 1,594 0.743 + 1,486 3 5,000 31,000 +26,000 0.712 +18,512 0.641 +16,666 4 5,000 19,000 + 14,000 0.636 + 8,904 0.552 + 7,728 Total 45,000 57,000 + 12,000 3.038 + 2,220 2.798 + 20 Net present worth at 12 percent = 2,220,000 Internal rate of return = 16 percent Benefit-cost ratio at 12 percent = 1.06a N/K ratio at 12 percent = 29,010 - 26,790 = 1.08 Source: Table 9-1. a. The derivation of the benefit-cost ratio is not given in this table. Table 9-20. Treatment of Depreciation in Discounted Measures of Project Worth (thousands of currency units) Value of Incremental cost incremental production Incremental Discount Present Capital Produc- (gross net benefit factor worth Year items tton Gross benefit) (cash flow) 0% 0% 1 1,000 0 1,000 0 -1,000 1 000 -1,000 2 - 50 50 300 + 250 1.000 + 250 3 50 50 300 + 250 1.000 + 250 4 - 50 50 300 + 250 1 000 + 250 5 - 50 50 300 + 250 1.000 + 250 Total 1,000 200 1,200 1,200 0 5 000 0 Net present worth at 0 percent = 0 Internal rate of return = 0 percent Benefit-cost ratio at 0 percent = 1,200 1,200 = 1.00 N/K ratio at 0 percent = 1,000 - 1,000 = 1.00 COMPARING PROJECT cosrS AND BENEFITS 355 rate of return of zero or greater, and when the benefit-cost ratio or net benefit-investment ratio is I at a zero or greater rate of interest. We do not need to include depreciation separately as a "cost" in analyzing our project. It is automatically taken care of in the computational process. (There is another convenience-we do not need to make any decision about what depreciation schedule to use, a notoriously difficult and arbitrary choice that is essentially an accounting, not an economic, problem.) Of course, if the net present worth at zero discount rate is less than zero, if the internal rate of return is less than zero, or if the benefit-cost ratio or the net benefit-investment ratio at zero rate of interest is less than 1, then we not only would have earned nothing, but actually would not even have recovered all our costs. Length of the Project Period For how long a period should the analyst carry out the economic analysis? The general rule is to choose a period of time that will be roughly comparable to the economic life of the project. If the project requires a fairly sizable initial capital investment in one kind of asset, such as tubewells or an orchard, a convenient starting point for establishing the period of the analysis is the technical life of the major investment item. In some projects, however, the technical life of the major investment may be quite long, but the economic life of the item is expected to be much shorter because of technological obsolescence. This may be a problem in industrial projects and in some kinds of transport projects, but it is rather uncommon in agricultural projects. Even so, the analyst might expect that the economic life of a processing plant that produces frozen foods would be shorter than the technical life of the equipment, or even that the equipment for producing broiler chickens might become obsolete before it is completely worn out. In most agri- cultural projects, however, we do not anticipate that rapidly changing technology will make a major investment obsolete over a period of twenty to twenty-five years. When the economic life of the project is not limited by considerations of obsolescence, and the technical life of the major investment asset extends beyond about twenty-five years, another consideration comes into play that helps to establish a reasonable economic life for the project and, hence, for the economic project analysis. At the discount rates we are talking about and the opportunity costs for capital we think exist in developing countries, any return to an investment beyond about twenty- five years will probably make no difference in project selection. As a result, few agricultural project analyses need to be carried out beyond twenty-five years. But if the technicians working on the project feel the analyst should carry out the economic analysis for a longer period be- cause coconuts will bear for forty years or because a dam can reasonably be expected to last fifty years, then it may be easier for the analyst simply 356 MEASURES OF PROJECT WORTH to run the calculations through to a period that satisfies the technicians rather than to discuss the matter further. It is better to save the discus- sion for the difficult problems of project design and implementation. To illustrate that extending the economic analysis beyond twenty-five years makes little difference in project selection, we may take two approaches: looking at the discount factors themselves and running an illustrative internal rate of return. First, the discount factors. Suppose the proposed project is a large dam. We can reasonably expect the dam to last well over fifty years, even though its effectiveness after fifty years may be greatly reduced because of silting. Yet look at the effect on the present worth (and, hence, on present decisionmaking) of that distant benefit. At 14 percent, any benefit received in the fiftieth year is worth today only one-thousandth of its face value-a thousand currency units of return in fifty years is worth only one currency unit today. Beyond fifty years, this dwindles to such a minor amount that it is even difficult to find a table that gives the discount factors. Even if we are talking about extending the period of analysis from twenty-five to fifty years, the difference these additional twenty-five years make is rather minor. Again, looking at the discount factors: Present worth of an annuity factor for fifty years at 14 percent 7.133 Less present worth of an annuity factor for twenty-five years at 14 percent -6.873 Present worth of an annuity factor for twenty-sixth through fiftieth years at 14 percent 0.260 Doubling the life of the project by adding twenty-five years to the analysis only increases the total present worth of the project by about one-fourth of one year's annual net benefit. Put another way, the net benefit from the twenty-sixth to the fiftieth year is worth today only about three months' worth of the same net benefit during the first year. The calculation in table 9-21, drawn from the Lilongwe Development Program in Malawi, shows the effect on the internal economic return of extending the length of the project period. (The symbol for Malawi pounds is M£. Since this project was prepared, the currency unit of Malawi has been changed to kwachas, MK.) Doubling the assumed life of the project (and assuming no more investment) increases the economic rate of return by only 1 percent, from 13 percent to 14 percent. Given the probable error in estimating yields, prices, and rate of acceptance by farmers, this difference is meaningless. How Far to Carry Out Computations of Discounted Measures In agricultural projects, it is misleading to carry out the computations of discounted measures very far. The underlying estimates of the data are COMPARING PROJECT COSTS AND BENEFITS 357 Table 9-21. Effect on Economic Rate of Return of Doubling Project Life from Twenty-five to Fifty Years, Lilongwe Development Program, Malawi (thousands of ME) Incremental Discount Present Discount Present net benefit factor worth factor worth Year (cash flow) 10% 10% 15% 15% Assuming project life of twenty-five years 1 - 920 0.909 - 836 0.870 -800 2 - 569 0.826 - 470 0.756 -430 3 - 556 0.751 - 418 0.658 -366 4 - 492 0.683 - 336 0.572 -281 5 - 360 0.621 - 224 0.497 -179 6 - 164 0.564 - 92 0,432 - 71 7 + 30 0.513 + 15 0.376 + 11 8 + 372 0.467 + 174 0.327 +122 9 + 563 0.424 + 239 0.284 +160 10 + 650 0.386 + 251 0.247 +161 11 + 710 0.350 + 248 0.215 +153 12 + 751 0.319 + 240 0.187 +140 13 + 781 0.290 + 226 0.163 +127 14-25 + 884 1974b +1,745 0.881b +779 Total +11,404 9.077 + 762 6.465 -474 Economic rate of return = 10 + 5(762 - 1,236) = 13 percent Assuming project life of fifty years 1-25' +11,404 9.077 + 762 6.465 -474 26-50 + 884d 0.8381 + 741 0.197e +174 Total + 33,504 9.915 + 1,503 6.662 -300 Economic rate of return = 10 + 5(1,503 - 1,803) = 14 percent M£ Malawi pounds (since this project was prepared, the currency unit in Malawi has been changed to kwachas, or MK). Source: Adapted from World Bank, "Lilongwe Development Program," TO-610a (Washington, D.C., 1968; restricted circulation), annex 4. a. Annual amount for years 14 through 25 inclusive. To reach column total, this amount must be included 12 times. b. Present worth of an annuity factor for years 14 through 25 inclusive. See the subsec- tion on "Present worth of a stream of future income" for method of computation. c. From total line in first section of the table. d. Annual amount for years 26 through 50 inclusive. To reach column total, this amount must be included 25 times. e. Present worth of an annuity factor for years 26 through 50 inclusive. See the subsection on "Present worth of a stream of future income" for method of computation. so inaccurate at best that carrying out the computations to many deci- mal places implies a spurious precision. For net present worth, it is normal to report the result in the nearest thousand or million currency units, although in smaller projects the result may sometimes be given in the nearest unit. Financial and economic rates of return are best rounded to the nearest whole percentage point. Since extremely high internal rates of return are difficult to interpret on theoretical grounds, it is better to report them simply as being very high. As a practical limit, I would suggest not giving 358 MEASURES OF PROJECT WORTH internal rates of return greater than 50 percent. Above that value, finan- cial or economic rates of return may be reported as "over 50 percent." In general, benefit-cost and net benefit-investment ratios are best rounded to the nearest hundredth of a ratio value. Thus, a benefit-cost or a net benefit-investment ratio for which the computation results in a value of 1.434 would be reported as 1.43. To determine discounted measures of project worth at these levels of accuracy, discount factors of three decimal places are sufficient. This being so, the summary tables in appendix B may be used conveniently and with confidence to determine discounted measures of project worth and to perform most other project computations in which use of such tables is appropriate. When the analyst includes discounted measures of project worth in a project report, it is unnecessary to show the details of the discounting computation in the summary presentations (such details may be in- cluded in an annex to the report). A notation in the main text and at the bottom of the summary tables about the net present worth, the economic or financial rate of return, the benefit-cost ratio, or the net benefit- investment ratio is enough. If how the analyst arrived at the cash flow or the gross cost and benefit is clearly presented, those who are familiar with the analytical techniques will be able to understand how the dis- counting computation was carried out. If the analyst is presenting the results of a financial analysis to show a financial rate of return, the point of view assumed in the analysis must be clearly specified. The entry should read "financial rate of return to all resources engaged," "financial rate of return to equity before income taxes," "financial rate of return to the farmer's own resources," or some similar, specific statement. Comparisons among Discounted Measures The interrelations of the four discounted measures of project worth can be clearly specified. The internal rate of return is that discount rate which just makes the net present worth of the project equal zero and the benefit-cost ratio and net benefit-investment ratio equal 1. Taking the opportunity cost of capital as the discount or cut-off rate, from any array of possible project alternatives all four discounted mea- sures of project worth will identify exactly the same group of projects for implementation, although (as discussed above) mutually exclusive proj- ects will have to be subjected to further tests if the internal rate of return, benefit-cost ratio, or net benefit-investment ratio criteria are used. For net present worth, internal rate of return, and benefit-cost ratio, the formal criterion is to accept all projects that meet the test-that is, that have a positive net present worth at the opportunity cost of capital, have an internal rate of return above the opportunity cost of capital, or have a benefit-cost ratio of 1 or greater at the opportunity cost of capital. For the net benefit-investment ratio, the formal selection criterion is to accept COMPARING PROJECT COSTS AND BENEFITS 359 projects discounted at the opportunity cost of capital in order, beginning with the largest ratio value and continuing until all investment funds have been exhausted. Which discounted measure the analyst chooses will depend on the practice in the country in which he is working or on the preference of the financing agency that will be approached to lend for the project. Many project analysts prefer the net present worth criterion for its simplicity, unambiguous quality, and straightforward way of selecting among mutually exclusive projects. They reject the argument that the necessity to establish a reasonable estimate of the opportunity cost of capital before the net present worth can be calculated is a valid objection to use of this measure. They argue that in any event a nation should face up to this task. Some analysts prefer the internal rate of return criterion be- cause it is more easily understood by those not familiar with the dis- counted measures. The internal rate of return can readily be explained as the maximum rate of interest that a project could pay if all resources were borrowed; it thus can be explained as a measure of the return on the resources engaged in the project. The World Bank has tended to use the internal rate of return as its principal discounted measure because the internal rate of return avoids making a close comparison of the opportu- nity cost of capital in the Bank's various member countries or setting a worldwide opportunity cost of capital. The net benefit-investment ratio provides a means of ranking independent (not mutually exclusive) proj- ects. As noted earlier, the benefit-cost criterion is infrequently used in developing countries. In virtually all actual project analyses, the practice is to work out a project and to make the best estimate of the results expressed in one of the discounted measures. Then the project may be selected if it has a net present worth of zero or greater, an internal rate of return equal to or above the cut-off rate, or a benefit-cost ratio or a net benefit-investment ratio of 1 or greater. The criteria, thus, are used on a "go-no-go" basis. Many administrators, however, intuitively tend to rank projects on the basis of the internal rate of return or the benefit-cost ratio. We have noted that, although in a very rough sense projects can be ranked in this manner, it is better not to do this, for it can lead to an erroneous invest- ment decision. It is preferable to use the net benefit-investment ratio to rank projects. The fact of the matter is that ranking is generally unneces- sary and so is much better avoided. Rarely can a nation afford to have a "shelf" of fully prepared projects ready to implement and in need of ranking. The demands of economic development are too urgent and the costs of preparing projects too great. Choice among projects that meet the formal criteria of acceptance is related not to the rank of the projects by a discounted measure of worth but on other, noneconomic grounds- including the ability to implement the projects. Given these realities, the ranking issue is a false one. It is sufficient for economic analysis to establish a realistic opportunity cost of capital and accept for imple- mentation those projects which meet such other criteria as regional and sectoral balance, effect on low-income farmers, or administrative feasi- Table 9-22. Comparison of Discounted Measures of Project Worth Net present worth Internal rate of Benefit-cost Net benefit-investment Item (NPW) return (IRR) (B/C) ratio (N/K) ratio Selection Accept all independent Accept all independent Accept all independent Accept all independent projects with criterion projects with NPW of zero projects with IRR equal to projects with B/c ratio N/K ratio of I or greater when or greater when or greater than of I or greater when discounted at opportunity cost of discounted at opportunity cost of discounted at capital in order of ratio value opportunity cost of capital opportunity cost of until available investment funds capital (see "Mutually capital are exhausted exclusive alternatives," below) Ranking Gives no ranking for order May give incorrect May give incorrect May be used to rank independent of implementation ranking among ranking among projects independent projects independent projects Mutually Accept alternative with Cannot be used directly; Cannot be used directly Cannot be used directly exclusive largest NPW when must discount differences alternatives discounted at between incremental net opportunity cost of benefit flows of mutually capital (NPw is the exclusive alternative preferred selection projects criterion for mutually exclusive alternatives) Discount Must determine a suitable Determined internally; Must determine a suitable Must determine a suitable rate discount rate, generally must determine oppor- discount rate, generally discount rate, generally the opportunity cost of tunity cost of capital the opportunity cost of the opportunity cost of capital to use as a cut-off rate capital capital COMPARING PROJECT COSTS AND BENEFITS 361 bility and which also are economically attractive as indicated by one of the discounted measures of project worth. In summary, and for easy reference, some of the contrasts among the net present worth, the internal rate of return, the benefit-cost ratio, and the net benefit-investment ratio are compared in table 9-22. Appendix. Mathematical Formulations of Discounted Measures of Project Worth The formal mathematical statements of the discounted measures of project worth discussed in this chapter are given below. Net present worth: t= B, - C, (1 + i)t Internal rate of return: The discount rate i such that t=n B, -C =0. r=1 (1 + O) Benefit-cost ratio: (1 + i)' tin B, t= (1 + O)t Net benefit-investment (N/K) ratio: (1+ i), t= K, t=I (1 + i)t In the four mathematical formulations, Bt = benefit in each year C, = cost in each year N, = incremental net benefit in each year after stream has turned positive K, = incremental net benefit in initial years when stream is nega- tive t= 1, 2, . . . , n n = number of years i= interest (discount) rate. � ,,.х,;'�9" ,� ,,;.�w. `° } л . �I' � ,., � * ��"�, � «Н '° '( � � ,��. '�+�. 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'� � � �`� � � { � _ ��= �� . , � _� л �..,,,.� ;�„ . ,. t � ,�УуΡ • � - '� , � • �'��ь�.'�[ + � _, ц � " 4! . г .,, Ё у�� '.' � �' . _ .� ��У�, п д" � � '� гц-� �..�� ' � ' � • , s8 . _ ; F.'' _�*. � � � , д � '�" � '� �� . � '---- / . �ам�w,. г __ __- - � �" ° `�` �� 10 App ly ing' Discounted Measures Of Project Worth WHEN APPLYING discounted measures of project worth in financial and economic analysis of proposed projects, the analyst may encounter some practical questions about their use. I will address several of these ques- tions in this chapter. Sensitivity Analysis (Treatment of Uncertainty) One of the real advantages of careful economic and financial project analysis is that it may be used to test what happens to the earning capacity of the project if events differ from guesses made about them in planning. How sensitive is a project's net present worth at financial prices and economic values, or its financial and economic rate of return or net benefit-investment ratio, to increased construction costs? To an extension of the implementation period? To a fall in prices? Reworking an analysis to see what happens under these changed circumstances is called sensitivity analysis. It is one means of drawing attention to a central reality of project analysis: projections are inevitably subject to a high degree of uncertainty about what will actually happen. Facing page: Plucking tea in Java, Indonesia. 363 364 MEASURES OF PROJECT WORTH All projects should be subjected to sensitivity analysis. In agriculture, projects are sensitive to change in four principal areas. These, and the technique of sensitivity analysis, are considered below. Price Probably every agricultural project should be examined to see what happens if the assumptions about the sale price of the project's product prove wrong. For this the analyst can make alternative assumptions about future prices and see how these affect the net present worth, the financial and economic rates of return, or the net benefit-investment ratio (often abbreviated as N/K ratio). Testing a project to see what will happen to the measures of project worth when different shadow prices are assumed is also a kind of sensi- tivity analysis. The analyst could examine a project to see the effect of using the market wage for labor or a shadow price, the official exchange rate or a foreign exchange premium, and so forth. Because of the difficul- ties in establishing shadow prices, if the project turns out to be relatively insensitive to shadow pricing, it may be better to present the analysis in market prices and to note that the net present worth, the economic rate of return, and the net benefit-investment ratio are relatively insensitive to shadow prices. Delay in implementation Delay in implementation affects most agricultural projects. Farmers may fail to adopt new practices as rapidly as anticipated, or they may find it harder to master new techniques than was thought. Other techni- cal difficulties may be underestimated. There may be delays in ordering and receiving new equipment. Unavoidable administrative problems and requirements may delay the project. Testing to determine the effects of delay on the net present worth, the financial and economic rates of return, and the net benefit-investment ratio of a proposed agricultural investment is an important part of the sensitivity analysis. Cost overrun Almost every agricultural project should be tested for sensitivity to cost overrun. Projects tend to be very sensitive to cost overrun-espe- cially for construction-because so often the costs are incurred early in the project when they weigh heavily in the discounting process and are for facilities that must be complete before any benefit can be realized. A project that has a quite attractive return if the estimated cost is in fact realized may be only marginally acceptable or unacceptable if costs early in the implementation phase rise significantly. Cost estimates often are not very firm-one more reason projects should be tested for cost overrun. In many project analyses there is considerable uncertainty about the prices that actually will have to be APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 365 paid for supplies and equipment. There is a tendency, too, for technicians and project analysts to make their cost estimates on the basis of overopti- mistic implementation schedules and assumptions about prices for proj- ect inputs. It is projects with substantial construction components that must be most carefully tested for cost overrun. We noted under "Accuracy of Agricultural Project Analyses. Implementation experience" in chapter 1 that it is large-scale groundwater projects, with their substantial con- struction element that must be completed before any water can flow, that have the worst record for cost overrun among the principal kinds of projects assisted by World Bank financing. Characteristically, these proj- ects are very sensitive to cost overrun. Agricultural projects are less likely to be as sensitive to production costs that arise later in the life of the project, although in these instances, again, overruns for production costs may make an otherwise quite good project much less attractive. A test that shows a project to be very sensitive to cost overrun may signal to those who must make investment decisions that it is important to have firm cost estimates before proceeding with the final decision, even if obtaining firm estimates may mean a delay in the start of project implementation. If a project is particularly sensitive to cost overrun, it is also a signal to the project manager and those to whom he reports that it is important to contain costs if the project is to make its expected contribution to increasing national income. Yield The analyst may wish to test a proposed project for its sensitivity to errors in estimated yield. There is a tendency in agricultural projects to be optimistic about potential yields, especially when a new cropping pattern is being proposed and the agronomic information is based mainly on experimental trials. A test to determine how sensitive the project's net present worth, financial and economic rates of return, or net benefit-investment ratio are to lower yields not only may provide in- formation useful in deciding whether to implement the project, but also may emphasize the need to ensure sufficient extension services if the project is to be as high-yielding as could reasonably be expected. Technique of sensitivity analysis The technique of sensitivity analysis is not complicated. The analyst simply calculates the measure of project worth over again using the new estimates for one or another element of cost or return. The technique is illustrated in tables 10-1 through 10-3 for the Jatiluhur Irrigation Project in Indonesia. In this case, the most probable outcome of the project was listed (table 10-1), and then the project was tested for its sensitivity to a 30 percent cost overrun (table 10-2) and to a 10 percent fall in the price of rice (table 10-3). In these as in earlier tables of this kind, a convention has been adopted that lists the annual amount for each year when that Table 10-1. Sensitivity Analysis, Jatiluhur Irrigation Project, Indonesia: Most Probable Outcome (thousand millions of Rp) Incre- Incre- Incremental Discount Present Discount Present Discount Present mental mental net benefit factor worth factor worth factor worth Year cost benefita (cash flow) 12% 12% 20% 20% 25% 25% 1 0.5 - - 0.5 0.893 -045 0.833 -0.42 0.800 -0.40 2 2.1 0.4 - 1.7 0.797 -1.35 0.694 -1.18 0.640 -1.09 3 3.7 0.8 - 2.9 0712 -206 0.579 -1.68 0.512 -1.48 4 3 7 1 4 - 2.3 0.636 +1.46 0.482 - 1.11 0.410 -0.94 5 2.0 2.1 + 0.1 0.567 +0.06 0.402 +0.04 0.328 +0.03 6 05 2.5 + 2.0 0.507 +1.01 0.335 +0.67 0.262 +052 7-30 0.5b 2.9b + 2.4b 3.944 +947 1.653 +3 97 1 044 +2.51 Total 24.5 768 +52.3 8.056 +8.14 4978 +0.29 3.996 -0.85 Net present worth at 12 percent = Rp + 8.14 Economic rate of return = 20 + 5(0.29 - 1.14) 20 + 5(0.25) = 21 percent Net benefit-investment (N/K) ratio at 12 percent Rpl2.00 - Rp3.86 = 3 11 Rp Indonesian rupiahs. a. Assumes only an improvement in water control; that is, no accompany- Source: Adapted from World Bank, "Djatiluhur Irrigation Project-Indone- ing increase in the use of modern inputs sia," PA-37 (Washington, D.C., 1970; restricted circulation), p. 26 and annex b. Annual amount for years 7 through 30 inclusive To reach column total, 10, p. 1. Since this report was published, a spelling reform has changed the this amount must be included 24 times. This same convention is adopted spelling of the project area to Jatiluhur. wherever it is relevant for all tables in this chapter. Table 10-2. Sensitivity Analysis, Jatiluhur Project: Assuming 30 Percent Cost Overrun (thousand millions of Rp) Incre- Incre- Incremental Discount Present Discount Present Discount Present mental mental net benefit factor worth factor worth factor worth Year cost benefita (cash flow) 12% 12% 15% 15% 20% 20% 1 0.6 - - 0.6 0.893 -0.54 0.870 -0.52 0.833 -0.50 2 2.7 0.4 - 2.3 0.797 -1.83 0.756 -1.74 0.694 -1.60 3 4.8 0.8 - 4.0 0.712 -2.85 0.658 -263 0.579 -2.32 4 4.8 1.4 - 3.4 0.636 -2.16 0.572 -1.94 0.482 -1.64 5 2.6 2.1 - 0.5 0.567 -0.28 0.497 -0.25 0.402 -0.20 6 0.6 2.5 + 1.9 0.507 +096 0.432 +0.82 0.335 +0.64 7-30 0.6 2.9 + 2.3 3.944 +9.07 2.782 +6.40 1.653 +3.80 Total 30.5 76.8 +46.3 8.056 +2.37 6.567 +0.14 4.978 -1.82 Net present worth at 12 percent = Rp+ 2.37 Economic rate of return = 15 + 5(0.14 - 1.96) = 15 + 5(0.07) = 15 percent N/K ratio at 12 percent = Rp10 03 - Rp7.66 = 1.31 Source: Same as table 10-1. a. Assumes only an improvement in water control; that is, no accompany- ing increase in the use of modern inputs. Table 10-3. Sensitivity Analysis, Jatiluhur Project: Assuming 10 Percent Lower Price of Rice (thousand millions of Rp) Incre- Incre- Incremental Discount Present Discount Present Discount Present mental mental net benefit factor worth factor worth factor worth Year cost benefit' (cash flow) 12% 12% 15% 15% 19%b 19% 1 0.5 - - 0.5 0.893 -0.45 0.870 -0.44 0.840 -0.42 2 2 1 0.4 - 1.7 0.797 -1.35 0.756 -1.29 0706 -1.20 3 3.7 0.7 - 3.0 0712 -2.14 0.658 -1 97 0.593 -1.78 4 3.7 1.3 - 2.4 0636 -1.53 0.572 -1.37 0.499 -1.20 5 2.0 1.9 - 0 1 0.567 -0.06 0.497 -0.05 0.419 -0.04 6 0.5 2.2 + 1.7 0.507 +0.86 0432 +0.73 0.352 +0.60 7-30 0.5 2.6 + 2.1 3.944 +8.28 2.782 +5 84 1.825 +3.83 Total 24.5 68.9 +44.4 8.056 +3.61 6567 +1.45 5.234 -0.21 Net present worth at 12 percent Rp+ 3.61 Economic rate of return = 15 + 4(1.45 1.66) = 15 + 4(0.87) = 18 percent N/K ratio at 12 percent = Rp9.14 - Rp5.53 = 1 65 Source: Same as table 10-1. b. For a discussion of the interpolation interval, see the subsection on a Assumes only an improvement in water control, that is, no accompany- "Choosing the discount rate," chapter 9. ing increase in the use of modern inputs. APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 369 amount is constant over several years. Thus, to reach the total in- cremental net benefit in table 10-1 of Rp52.3 thousand million, the annual amount of Rp2.4 thousand million must be included 24 times [- 0.5 - 1.7 - 2.9 - 2.3 + 0.1 + 2.0 + 24(2.4) = 52.3]. (The symbol for Indonesian rupiahs is Rp.) Note what happened to the wealth-generating potential of the project under this sensitivity test. When a 30 percent cost overrun was assumed (table 10-2), the net present worth, assuming a 12 percent opportunity cost of capital, fell 71 percent, from Rp8.14 thousand million to Rp2.37 thousand million [(8.14 - 2.37) + 8.14 x 100 = 71]; the economic rate of return fell by 29 percent, from 21 percent to 15 percent [(21 - 15) + 21 x 100 = 29]; and the net benefit-investment ratio, also assuming a 12 percent opportunity cost of capital, fell by a factor of 2.37 (3.11 + 1.31 = 2.37). When a 10 percent reduction in the price of rice was assumed (table 10-3), the net present worth fell 56 percent, from Rp8.14 thousand mil- lion to Rp3.61 thousand million [(8.14 - 3.61) + 8.14 x 100 = 56]; the economic rate of return fell by 14 percent, from 21 percent to 18 percent [(21 - 18) + 21 x 100 = 14]; and the net benefit-investment ratio was cut in half [(3.11 - 1.65) + 3.11 = 0.47]. With these possible outcomes known, whoever must make the project decision may now ask whether it is worth running the risk of that large a drop in the worth of the project, given how likely the cost overrun (or the lower price) will be. The higher the expected yield, the more sensitive the project. Projects will also be more sensitive to earlier items than to later ones-a direct consequence of the time value of money. Thus, in general, projects tend to be more sensitive to cost overruns that occur early in the project life than to price changes that occur later. Usually, too, a given proportionate change in a major cost or return item will have a more than proportion- ate effect on the measures of project worth. In the Jatiluhur project in tables 10-1 through 10-3, for example, a 10 percent fall in the price of rice reduced the net present worth by 56 percent, the economic rate of return by 14 percent, and the net benefit-investment ratio by half. No general rule about these relations can be cited. Each sensitivity analysis must be undertaken separately to estimate the effect of a change in assumptions on the worth of the project, and then a judgment must be made about how likely that change will be. Sensitivity analysis not only has important implications for invest- ment decisions, it also has very important implications for project man- agement. Suppose a project turns out to be particularly sensitive to delay. If senior decisionmakers are aware of how sensitive the project is and how much delay will cost the nation in lost opportunities to generate wealth, these decisionmakers may be willing to cut "red tape"-to en- sure that there will not be unnecessary delays in processing financing and other requests from the project and that prompt cooperation will be forthcoming from the agencies that must support the project. Or, it may be decided that the likelihood of delay is so substantial-no matter how effective the project manager is-that it is better to redesign the project to make it more manageable and to permit postponing some costs if Table 10-4. Switching Values, Cotton Processing and Marketing Project, Kenya: Most Probable Outcome (thousands of KSh) Incre- Incre- Incremental Discount Present Discount Present Discount Present Fiscal mental mental net benefit fictor worth factor worth factor worth year cost benefit (cash flow) 12% 12% 20% 20% 25% 25% 1982 93,004 5,761 - 87,243 0.893 - 77,908 0.833 -72,673 0.800 -69,794 1983 101,140 22,833 - 78,307 0.797 - 62,411 0.694 -54,345 0.640 -50,116 1984 98,049 46,177 - 51,872 0.712 - 36,933 0.579 -30,034 0.512 -26,558 1985 56,135 71,119 + 14,984 0.636 + 9,530 0482 + 7,222 0.410 + 6,143 1986 25,385 80,385 + 55,000 0.567 + 31,185 0.402 +22,110 0.328 +18,040 1987 31,804 91,348 + 59,544 0507 + 30,189 0,335 +19,947 0.262 +15,601 1988 24,308 94,178 + 69,870 0.452 + 31,581 0.279 + 19,494 0.210 + 14,673 1989 24,032 96,915 + 72,883 0.404 + 29,445 0.233 + 16,982 0.168 + 12,244 1990 23,962 98,097 + 74,135 0.361 + 26,763 0.194 +14,382 0.134 + 9,934 1991 21,314 98,097 + 76,783 0322 + 24,724 0 162 +12,439 0.107 + 8,216 1992 26,145 98,097 + 71,952 0.287 + 20,650 0.135 + 9,714 0.086 + 6,188 1993 22,476 98,097 + 75,621 0.257 + 19,435 0.112 + 8,470 0.069 + 5,218 1994 23,289 98,097 + 74,808 0.229 + 17,131 0.093 + 6,957 0.055 + 4,114 1995 24,641 98,097 + 73,456 0.205 + 15,058 0078 + 5,730 0.044 + 3,232 1996 18,797 98,097 + 79,300 0.183 + 14,512 0065 + 5,155 0.035 + 2,776 1997 26,164 98,097 + 71,933 0.163 + 11,725 0.054 + 3,884 0.028 + 2,014 1998 23,622 98,097 + 74,475 0.146 + 10,873 0.045 + 3,351 0.023 + 1,713 1999 24,641 98,097 + 73,456 0 130 + 9,549 0.038 + 2,791 0.018 + 1,322 2000 22,124 98,097 + 75,973 0.116 + 8,813 0.031 + 2,355 0.014 + 1,064 2001 19,030 98,097 + 79,067 0.104 + 8,223 0.026 + 2,056 0.012 + 949 Total 730,062 1,685,880 +955,818 7.471 +142,134 4.870 + 5,987 3.955 -33,027 Net present worth at 12 percent = KSh+ 142,134 Economic rate of return = 20 + 5(5,987 - 5,987 + 33,027) = 20 + 5(0.15) = 21 percent N/K ratio = 319,386 - 177,252 = 1.80 KSh Kenyan shillings. ing Project, Staff Appraisal Report," 3355-KE (Washington, D.C., 1981, re- Source: Adapted from World Bank, "Kenya, Cotton Processing and Market- stricted circulation), pp. 50 and 62. APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 371 necessary so that the project is less sensitive to delay. This may be desirable even though redesigning the project may somewhat reduce the overall net present worth, rate of return, or net benefit-investment ratio. Sensitivity analysis is a straightforward (but often quite sufficient) means of analyzing the effects of risk and uncertainty in project analysis. A much more elaborate technique of risk analysis using probability theory and requiring use of a computer is outlined by Reutlinger (1970) and Pouliquen (1970). That approach is generally called "probability analysis." In contrast, the techniques we have been discussing (includ- ing sensitivity analysis) are usually called "most probable outcome analysis." Switching Value A variation of sensitivity analysis is the "switching value." In straight- forward sensitivity analysis we choose an amount by which to change an important element in the project analysis and then determine the impact of that change on the attractiveness of the project. In contrast, when we calculate a switching value we ask how much such an element would have to change in an unfavorable direction before the project would no longer meet the minimum level of acceptability as indicated by one of the measures of project worth. Then those responsible for determining whether to proceed with the project can ask themselves how likely they feel it is that there will be a change of that magnitude. We may illustrate computation of the switching value with an illustra- tion taken from the Kenya Cotton Processing and Marketing Project. The project provides for improved purchasing and transport of seed cotton and for better ginning facilities. The opportunity cost of capital in Kenya at the time of the analysis was estimated to be 12 percent. The most probable outcome estimate, laid out in table 10-4, shows that the project would have a net present worth of KSh+ 142,134 at a 12 percent opportunity cost of capital, an economic rate of return of 21 percent, and a net benefit-investment ratio of 1.80 at the opportunity cost of capital. (The symbol for Kenyan shillings is KSh.) One switching-value test the analyst undertook was to determine by what proportion the benefit would have to be reduced before the net present worth would fall to zero-the zero value, of course, would make the economic rate of return exactly 12 percent and the net benefit- investment ratio exactly 1. The computation is laid out in table 10-5. The analyst determined the net present worth at various assumed levels of benefit shortfall. At a 25 percent shortfall, the net present worth at a 12 percent opportunity cost of capital is KSh + 11,985. At a 30 percent shortfall, however, the project has a negative net present worth of KSh - 14,044. To determine the shortfall that would make the net pres- ent worth just equal zero, the analyst interpolated between the positive net present worth at 25 percent and the negative net present worth at 30 percent in a manner analogous to the interpolation done to determine the Table 10-5. Switching Values, Kenya Cotton Project: Assuming Benefit Shortfall (thousands of KSh) Assuming 25% shortfall in benefit Assuming 30% shortfall in benefit Assuming 27% shortfall in benefit Incremental Present Incremental Present Present Fiscal Incremental net benefit worth Incremental net benefit worth Incremental Net benefit worth year benefit' (cash flow)b 12% benefit (cash flow)b 12% benefita (cash flow)b 12% 1982 4,321 - 88,683 -79,194 4,033 - 88,971 -79,451 4,206 88,798 -79,297 1983 17,125 - 84,015 -66,960 15,983 - 85,157 -67,870 16,668 - 84,472 -67,324 1984 34,633 - 63,416 -45,152 32,324 - 65,725 -46,796 33,709 - 64,340 -45,810 1985 53,339 - 2,796 - 1,778 49,783 - 6,352 - 4,040 51,917 - 4,218 - 2,683 1986 60,289 + 34,904 +19,791 56,270 + 30,885 +17,512 58,681 + 33,296 +18,879 1987 68,511 + 36,707 +18,610 63,944 + 32,140 +16,295 66,684 + 34,880 +17,684 1988 70,634 + 46,326 +20,939 65,925 + 41,617 +18,811 68,750 + 44,442 +20,088 1989 72,686 + 48,654 + 19,656 67,841 + 43,809 + 17,699 70,748 + 46,716 + 18,873 1990 73,573 + 49,611 +17,910 68,668 + 44,706 +16,139 71,611 + 47,649 +17,201 1991 73,573 + 52,259 +16,827 68,668 + 47,354 + 15,248 71,611 + 50,297 +16,196 1992 73,573 + 47,428 +13,612 68,668 + 42,523 +12,204 71,611 + 45,466 +13,049 1993 73,573 + 51,097 +13,132 68,668 + 46,192 +11,871 71,611 + 49,135 +12,628 1994 73,573 + 50,284 +11,515 68,668 + 45,379 +10,392 71,611 + 48,322 +11,066 1995 73,573 + 48,932 +10,031 68,668 + 44,027 + 9,026 71,611 + 46,970 + 9,629 1996 73,573 + 54,776 +10,024 68,668 + 49,871 + 9,126 71,611 + 52,814 + 9,665 1997 73,573 + 47,409 + 7,728 68,668 + 42,504 + 6,928 71,611 + 45,447 + 7,408 1998 73,573 + 49,951 + 7,293 68,668 + 45,046 + 6,577 71,611 + 47,989 + 7,006 1999 73,573 + 48,932 + 6,361 68,668 + 44,027 + 5,724 71,611 + 46,970 + 6,106 2000 73,573 + 51,449 + 5,968 68,668 + 46,544 + 5,399 71,611 + 49,487 + 5,740 2001 73,573 + 54,543 + 5,672 68,668 + 49,638 + 5,162 71,611 + 52,581 + 5,468 Total 1,264,414 +534,352 +11,985 1,180,119 +450,057 -14,044 1,230,695 +500,633 + 1,572 Proportionate fall that will make net present worth equal zero at 12 percent opportunity cost of capital = 25 + 5[11,985 - (11,985 + 14,044)] = 25 + 5(0.46) = 27 percent Source: Same as table 10-4. b. Most probable incremental cost from table 10-4 less incremental benefit a. Most probable incremental benefit in table 10-4 reduced by appropriate here. proportion. c. For a discussion of interpolation methodology, see the subsection on "Computing the internal rate of return" in chapter 9. APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 373 internal rate of return (see the subsection on "Computing the internal rate of return" in chapter 9). The computation is given at the bottom of table 10-5; it shows that the net present worth equals zero at 27 percent, rounded to the nearest whole percentage point. To verify, the net present worth is recomputed assuming a 27 percent benefit shortfall, and this gives a net present value of KSh + 1,572, not quite zero because the shortfall is rounded to the nearest whole percentage point. The analyst, thus, was able to note that "the project would have to suffer a shortfall in benefits by more than one-fourth (27 percent) before the rate of return fell to the opportunity cost of capital." Another switching value determined for the Kenya project was to find the maximum benefit delay before the net present worth of the project would fall to zero. The computation is laid out in table 10-6. The analyst computed the net present worth assuming the benefit to be delayed by one, two, and three years. When the benefit is delayed by two years, the net present worth at a 12 percent opportunity cost of capital is KSh + 19,375, so the project would still be acceptable. If the benefit were to be delayed for three years, however, the net present worth would become negative, with a value of KSh - 32,327, and the project would not be acceptable if judged solely on economic grounds. The analyst was thus able to report that "benefits would have to be lagged by more than two years without lagging costs at all before the rate of return would fall below 12 percent." Choosing among Mutually Exclusive Alternatives Quite often in project design, and not infrequently in evaluating com- plete projects, analysts are faced with having to choose among mutually exclusive alternatives-project design options or whole projects of a nature that if one is chosen the other cannot be undertaken. This can apply to such cases as development of surface irrigation and not tubewell irrigation, river development upstream rather than downstream, and plants in alternative locations but serving the same limited market. It can also apply to such design issues as the choice among different scales for projects in which one size precludes implementing a similar project of another size, the time phasing of what is essentially the same project, the different designs for project components, or the purposes of a multi- purpose project. The need to compare mutually exclusive design options is one of the principal reasons to apply economic analysis early in the project cycle. The preferred discounted measure of project worth for choosing among mutually exclusive projects or project options is the net present worth. Direct comparison of the internal rates of return, the benefit-cost ratios, or the net benefit-investment ratios can lead to an incorrect investment decision. This is so because undertaking a small, high-paying project may preclude generating more wealth through a moderately remunerative but larger alternative. Table 10-6. Switching Values, Kenya Cotton Project: Assuming Benefit Delay (thousands of KSh) Most probable outcome Benefit delayed 2 years Benefit delayed 3 years Incre- Incre- Incremental Present Incre- Incremental Present Incre- Incremental Present Fiscal mental mental net benefit worth mental net benefit worth mental net benefit worth year cost benefit (cash flow) 12% benefit (cash flow) 12% benefit (cash flow) 12% 1982 93,004 5,761 - 87,243 - 77,908 - - 93,004 -83,053 - - 93,004 -83,053 1983 101,140 22,833 - 78,307 - 62,411 - -101,140 -80,609 - -101,140 -80,609 1984 98,049 46,177 - 51,872 - 36,933 5,761 - 92,288 -65,709 - - 98,049 -69,811 1985 56,135 71,119 + 14,984 + 9,530 22,833 - 33,302 -21,180 5,761 - 50,374 -32,038 1986 25,385 80,385 + 55,000 + 31,185 46,177 + 20,792 + 11,789 22,833 - 2,552 - 1,447 1987 31,804 91,348 + 59,544 + 30,189 71,119 + 39,315 +19,933 46,177 + 14,373 + 7,287 1988 24,308 94,178 + 69,870 + 31,581 80,385 + 56,077 +25,347 71,119 + 46,811 +21,159 1989 24,032 96,915 + 72,883 + 29,445 91,348 + 67,316 +27,196 80,385 + 56,353 +22,767 1990 23,962 98,097 + 74,135 + 26,763 94,178 + 70,216 +25,348 91,348 + 67,386 +24,326 1991 21,314 98,097 + 76,783 + 24,724 96,915 + 75,601 +24,344 94,178 + 72,864 +23,462 1992 26,145 98,097 + 71,952 + 20,650 98,097 + 71,952 +20,650 96,915 + 70,770 +20,311 1993 22,476 98,097 + 75,621 + 19,435 98,097 + 75,621 +19,435 98,097 + 75,621 +19,435 1994 23,289 98,097 + 74,808 + 17,131 98,097 + 74,808 +17,131 98,097 + 74,808 +17,131 1995 24,641 98,097 + 73,456 + 15,058 98,097 + 73,456 + 15,058 98,097 + 73,456 + 15,058 1996 18,797 98,097 + 79,300 + 14,512 98,097 + 79,300 +14,512 98,097 + 79,300 +14,512 1997 26,164 98,097 + 71,933 + 11,725 98,097 + 71,933 +11,725 98,097 + 71,933 +11,725 1998 23,622 98,097 + 74,475 + 10,873 98,097 + 74,475 + 10,873 98,097 + 74,475 + 10,873 1999 24,641 98,097 + 73,456 + 9,549 98,097 + 73,456 + 9,549 98,097 + 73,456 + 9,549 2000 22,124 98,097 + 75,973 + 8,813 98,097 + 75,973 + 8,813 98,097 + 75,973 + 8,813 2001 19,030 98,097 + 79,067 + 8,223 98,097 + 79,067 + 8,223 98,097 + 79,067 + 8,223 Total 730,062 1,685,880 +955,818 +142,134 1,489,686 +759,624 +19,375 1,391,589 +661,527 -32,327 Net present worth at 12 percent assuming benefit delayed 2 years = KSh + 19,375 Net present worth at 12 percent assunung benefit delayed 3 years KSh -32,327 Source: Same as table 10-4. APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 375 Sometimes what may at first be posed as a pair of mutually exclusive projects can, instead, be seen as successive phases of development. If a small project can be expanded by phases to become a larger alternative, no analytical problem is posed. To implement a small, first-phase project does not preempt a larger, phase-two project; both phases can be under- taken, with each phase judged by any of the measures of project worth. Although net present worth is the preferred criterion for choosing among mutually exclusive alternatives, it is possible to manipulate the internal rate of return to use it to choose among mutually exclusive alternatives. The net benefit-investment ratio can be used to rank mutually exclusive projects only when the ratios of all projects in the investment program are known; therefore it is not a practical measure to use for this purpose. To use the internal rate of return to choose between two mutually exclusive alternatives, the cash flow of the smaller alternative is sub- tracted year by year from the cash flow of the larger alternative. This stream of differences is then discounted to determine the internal rate of return of the stream. This is the financial or economic rate of return to the additional resources necessary to implement the larger alternative as opposed to the smaller one. (Students of economics will recognize that we are, in effect, finding the marginal return for the marginal cost incurred.) How this method is applied will be illustrated in the course of our discussion of the kinds of mutually exclusive projects, below. When there are several mutually exclusive alternatives, determining the net present worth of each enables us to choose directly the best among them. In contrast, discounting the differences between cash flows of alternatives can only be applied to select between a single pair of alternatives. To use the internal rate of return criterion when there are more than two alternatives, one can proceed by determining the rate of return to the stream of the differences between any pair of alternatives. If the return is above the cut-off rate, the larger alternative is selected; if the return is below, the smaller is selected. The procedure is then repeated by testing the alternative chosen against another alternative, the better of this second pair is selected, and so forth in a kind of elimination tour- nament until all alternatives have been tested and the best identified. We will take up five instances of mutually exclusive alternatives: 1. The most general case is where we have entirely different alternative projects that are mutually exclusive-say, a choice between a small irrigation project that preempts a site and a larger one using the same site. 2. We will discuss the scale of a project as a variation of mutually exclusive alternatives, viewing a large project as a mutually exclusive alternative to a small version of the same project. 3. Another instance is the special case of timing-whether it would be better to begin a project now or later. In effect, postponing a project is a mutually exclusive alternative to undertaking it immediately. 4. Yet another special case involves the choice of alternative tech- Table 10-7. Measures of Project Worth of Alternative Irrigation Schemes: Small-scale Alternative (thousands of currency units) Discount Present Present Incremental Present Discount Present Discount Present Project Gross factor worth Gross worth net benefit worth factor worth factor worth year cost 12% 12% benefit 12% (cash flow) 12% 25% 25% 30% 30% 1 5000 0.893 4465 - -- - 500.0 -446.5 0.800 -400.0 0.769 -384.5 2 5.0 0.797 4.0 1400 111.6 + 135.0 + 107.6 0.640 + 864 0.592 + 79.9 3 50 0.712 3.6 140.0 997 + 135.0 + 96.1 0512 + 69.1 0.455 + 61.4 4 5.0 0636 3.2 140.0 890 - 135.0 + 85.9 0.410 + 55.4 0.350 + 47.2 5 5.0 0.567 2 8 140.0 79.4 + 135.0 + 76.5 0.328 + 44.3 0.269 + 36.3 6-20 50 3864 19.3 140.0 541.0 + 135.0 +521.6 1.265 +170.8 0.880 +1188 Total 595.0 7.469 479.4 2,660.0 9207 +2,065.0 +441.2 3 955 + 26.0 3.315 - 40.9 Net present worth at 12 percent +441 2 Economic rate of return = 25 + 5(26.0 - 66.9) = 25 + 5(0.39) = 27 percent N/K ratio at 12 percent = 887.7 - 446.5 - 1.99 APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 377 nologies, in which selection of one technology rules out its alternative. 5. The final case is that of additional purposes in multipurpose projects-the river basin project to control floods and generate hydropower that also includes an irrigation purpose is a mutu- ally exclusive alternative to the same project without the irriga- tion purpose. Entirely different projects Occasionally in agriculture we may be faced with the choice between two mutually exclusive alternative projects of an entirely different na- ture, one small and high-yielding and the other large but low-yielding. At a given location we may have a choice either of constructing a small irrigation project that is limited to the best land and uses rather simple equipment or of building a considerably larger project that involves a more extensive area and more costly, complicated engineering works. If the small scheme is built, it preempts the site so that the larger project cannot be built. When mutually exclusive alternatives of this nature are met, we can choose between them by selecting the project that has the larger net present worth when discounted at a suitable opportunity cost of capital. Tables 10-7 through 10-9 illustrate how these computations work and also why relying on a direct comparison of the internal rates of return or net benefit-investment ratios can lead to an erroneous investment deci- sion. In table 10-7, we have a highly remunerative, small-scale irrigation scheme costing 500 thousand currency units in project year I that preempts the.site available. At a 12 percent opportunity cost of capital, it has a net present worth of 441.2 thousand currency units. An alternative large-scale project costing 2,500 thousand currency units in project years 1 and 2 is presented in table 10-8. The large-scale project has a net present worth at a 12 percent opportunity cost of capital of 683.1 thousand currency units, and on the basis of the net present worth criterion we would select it. If we choose the smaller scheme, we would forgo a net present worth of 241.9 thousand currency units that would otherwise be available to the society (683.1 - 441.2 = 241.9). Recall that if the opportunity cost of capital is set correctly we would be able to implement all projects having a positive net present worth at that oppor- tunity cost. Although this approach requires an acceptable estimate of the opportunity cost of capital, if one is available then the method tells us easily and unambiguously which mutually exclusive alternative to accept. But if we compare the internal rates of return of the two projects, we find that the smaller project has an internal rate of return of 27 percent compared with 16 percent for the larger project. On this basis, we would choose the smaller project. A similar outcome would occur if we tried to use the net benefit-investment ratio to select between these mutually exclusive alternative projects. The smaller project has the larger net Table 10-8. Measures of Project Worth of Alternative Irrigation Schemes: Large-scale Alternative (thousands of currency units) Discount Present Present Incremental Present Discount Present Discount Present Project Gross factor worth Gross worth net benefit worth factor worth factor worth year cost 12% 12% benefit 12% (cash flow) 12% 15% 15% 20% 20% 1 1,500.0 0 893 1,339.5 - - - 1,500.0 - 1,339.5 0 870 - 1,305.0 0.833 - 1,249.5 2 1,000.0 0.797 797.0 - - - ,000.0 - 7970 0.756 - 756 0 0 694 - 694.0 3 100.0 0.712 71.2 350.0 2492 + 250.0 + 1780 0658 + 164.5 0.579 + 144.8 4 100.0 0 636 63.6 450.0 286.2 + 350.0 + 222.6 0.572 + 200.2 0.482 + 168 7 5 1000 0.567 56.7 550.0 311.8 + 450.0 + 255.2 0.497 + 223 6 0.402 + 180.9 6-20 100.0 3 864 386.4 6600 2,5502 + 5600 + 2,163 8 2907 + 1,627.9 1.879 + 1,0522 Total 4,300.0 7.469 2,7144 11,250.0 3,397.4 +6,950.0 + 683.1 6.260 + 155.2 4.869 - 396.9 Net presen worth at 12 percent = +683.1 Economic rate of return = 15 + 5(155.2 - 552.1) = 15 - 5(0 28) = 16 percent N/K ratio at 12 percent = 2,819.6 - 2,136.5 = 1.32 APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 379 benefit-investment ratio of 1.99, so we would select it over the larger project, which has a net benefit-investment ratio of only 1.32. But we know from the discussion of the application of the net present worth criterion that this would be an erroneous choice because we would be forgoing the additional wealth the larger project could create. When we use the internal rate of return criterion, we can avoid this error if we discount the differences between the cash flows of the two projects as is done in table 10-9. There we find that the internal rate of return to the stream of the differences is 14 percent. In other words, if we expand the project from the smaller alternative to the larger, the return to our additional investment is 14 percent. The proper choice criterion, then, is whether the return to our additional investment is above the cut-off rate. Since the cut-off rate in this example is taken to be 12 percent, the return on the additional investment would still be above the cut-off, and we would reject the smaller project in favor of the larger. Different scales of a project Sometimes we may wish to choose between a smaller version of a project and a larger version of the same project. Such a case arose in a Brazilian forestry project. The smaller version of the project consisted simply of cutting logs and exporting the round wood; it had a positive net present worth, quite a high economic rate of return, and an attractive net benefit-investment ratio. A somewhat larger version of the project in- cluded a sawmill; it had a larger net present worth than the smaller version, but a lower economic rate of return and a smaller net benefit- investment ratio. We could consider the larger version a mutually exclu- sive alternative to the smaller version. Applying the net present worth criterion, we would correctly choose the larger version. Note, however, that simply applying directly the economic rate of return or net benefit-investment ratio criterion would have led to an erroneous investment decision. In this case, undertaking the small project does not preempt the site. We can choose, if we wish, to undertake the small project and then proceed to expand it. Under these circumstances, we do our analysis not of the small version versus the large version, as if the two were mutually exclusive projects, but of the small version as the first phase of a two- phase program. By the net present worth criterion, we know from our earlier discussion that the smaller version, now called phase i, has a positive net present worth, so we would accept it. Then, if we tested the expansion necessary to reach the larger version, now called phase ii, we would find that this phase also has a positive net present worth, and so we would accept it, too. If we wanted to use the internal rate of return approach, the economic rate of return of the second phase of the program would be the economic rate of return of the differences between the incremental net benefit streams of the two versions. Similarly, the net benefit-investment ratio of the phase-n project would be the net benefit- investment ratio of the differences of the incremental net benefit streams Table 10-9. Measures of Project Worth of Aliernative Irrigation Schemes: Differences between Alternatives (thousands of currency units) Cash flow Cash flow of of Differences Discount Present Discount Present Project large-scale small-scale between fIactor worth factor worth year scheme scheme cash flows 12% 12% 15% 15% 1 - 1,5000 - 5000 -1,000.0 0893 - 893.0 0.870 - 870.0 2 -1,0000 -- 1350 -1,1350 0.797 - 904.6 0.756 - 858.1 3 + 2500 + 1350 + 1150 0.712 + 81.9 0.658 + 75.7 4 + 350 0 + 135.0 + 215.0 0.636 + 136.7 0.572 + 123.0 5 + 4500 + 1350 + 315.0 0567 + 178.6 0497 + 156.6 6-20 + 5600 + 1350 + 425.0 3.864 + 1,642 2 2.907 + 1,235 5 Total +6,9500 +2,065.0 +4,8850 7.469 + 241.8 6.260 - 137.3 Net present wvorth at 12 percent of the differences between incremental net benefit streams = + 241 8 Economic rate of return of the differences between incremental net benefit streams = 12 + 3(241 8 - 379.1) = 12 + 3(0 64) = 14 percent APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 381 of the two versions. Breaking a project down into phases is the more direct approach and the more easily understood. Such an approach permits us to apply any of our measures of project worth directly without further manipulation. Of course, if we have sufficient administrative and other resources, we may very well implement two phases-or even more-of a project simul- taneously. By analyzing each phase separately, we can tell directly from our analysis how large the project can be before we reach a phase that has a negative net present worth, an economic rate of return below our cut-off rate, or a net benefit-investment ratio less than that of alternative project opportunities. Different timing of a project A special case of the choice among mutually exclusive projects is the question of whether to begin a project immediately or to postpone it. The same project begun today or at some future time may be considered, from an analytical standpoint, to be two different, mutually exclusive projects. Postponing a project can be advantageous only if the potential benefit or cost stream will increase independently of when a project is begun. In most agricultural production projects, this is not the case. Rather, it is assumed that costs and benefits will come at some given period of time after the start of the project. If the project is postponed, both costs and benefits will also be postponed and for the same period of time. Questions of the best time to begin implementation can arise in agri- cultural projects when there is a processing facility to be constructed. We may want to establish sugar beets in a new area. We have an idea of the maximum rate at which we can expand the area for sugar beets given the limitations imposed by extension work, rates at which farmers will adopt new practices, and the like. We have a choice between shipping the beets to another area for processing-incurring both a transport cost and a loss of sucrose because of natural deterioration in the raw material-or building a new factory of a minimum economic size. Here we have a case where timing should be assessed. The potential benefit of the project grows independently of the beet factory up to its capacity because the benefit is dependent upon the rate at which farmers increase their output of beets. In the first years of the project it might be too expensive to provide for local processing, but at some point the savings in transport cost and sucrose loss will make it economic to build the factory. The problem is when is it most economic to begin. There are two general approaches commonly employed to determine the optimal time to begin a project. The simplest timing test to calculate, and probably the most widely used in practice, is the "first-year return" method. This technique makes an implicit assumption that once benefits begin they will be rising or constant, but this is the most common situation in all kinds of projects and so is not a serious drawback. In this test, the net benefit stream in the first year the stream is positive is 382 MEASURES OF- PROJECT woRrii divided by the total of the net benefit stream in those years it is negative. The result expressed in percentage terms is the first-year return. The optimal time to begin the project is the earliest year for which the net benefit stream for a project begun in that year has a first-year return exceeding the opportunity cost of capital. If the project begins earlier, for at least the first year it will fail to earn the opportunity cost of capital, and so it would be better to postpone implementation and use the money elsewhere. If the project begins later, a chance to earn the opportunity cost of capital on the initial investment will be passed by. The second timing test, somewhat more difficult to calculate than the first-year return test but the easiest test to interpret, is to compute the net present worth of the project by assuming it will begin in different years and by discounting at the opportunity cost of capital. (The same year is taken as to for all of the alternative net present worth computations.) The project should begin in that year when the net present worth is the greatest. Before that time, postponing the project will increase its net present worth at the given opportunity cost of capital; after that time, the net present worth of the project will be less than it need be. A very common instance of the need to determine optimal timing occurs in relation to traffic growth in road projects. The application of the methods of determining the optimal time to begin a project can be illustrated by the Kenya feeder road example laid out in table 10- 10. The cost of constructing the road, divided equally between two years, is estimated at KE760.0 thousand. (The symbol for Kenyan pounds is KE. Since this analysis was made, the unit of currency used in budgeting in Kenya has been changed from pounds to shillings, or KSh.) The road is assumed to have an economic life of thirty years. The earliest the project could have begun was 1970. Once the road was complete, there would be a two-year period while the traffic built up rapidly as people learned about the new road and new traffic was generated. After that, the traffic level would be determined by the general economic conditions of the area and was assumed to grow by 9 percent a year until 1991 and to be constant thereafter for the balance of the economic life of the road. The incremental net benefit streams given in table 10-10 are based on the benefit stream derived from the traffic estimates. (The traffic estimates were made on the basis of growth over 20 years on the assumption that the road was begun in 1970. It will be seen that, even if traffic were assumed to continue to grow after 1991, the optimal time to begin the project would not change.) A residual value was assumed that was based on linear depreciation in those cases where the benefit stream does not last a full thirty years. An opportunity cost of capital of 12 percent is assumed. To illustrate the first-year return method, we may consider the effect of beginning the road in 1973. The first year the net benefit stream is positive, it amounts to KE79.7 thousand, This is only 10 percent of the investment cost (taken to be the sum of the negative values of the net present worth stream), an indication that it is too soon to begin the project [79.7 - (380.0 + 380.0) x 100 = 10]. If we test for beginning the APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 383 road in 1974, the net benefit stream in the first year the net present worth is positive amounts to KE 86.4, which is only 11 percent of the investment, and it is still too early to begin [86.4 - (380.0 + 380.0) x 100 = 11]. But now if we test for beginning the road in 1975, when the net benefit stream the first year it is positive amounts to K£94.5 thousand, we find the first year return to be 12 percent [94.5+ (380.0 + 380.0) x 100 = 12]. Since 12 percent is our opportunity cost of capital, the first-year return method indicates that 1975 is the optimal year to begin the project. To determine the optimal time to begin the project using the net present worth method, the net present worth of the road was computed for each timing alternative from 1970 through 1977. The calculation took 1969 as to (that is, 1970 = tI). The net present worth reaches its greatest value of K£300.6 if the road were to be postponed five years and construc- tion begun in 1975. This, then, is the optimal timing alternative, a result consistent with that we obtained using the first-year return method. Beginning the road either before or after 1975 would result in a lower net present worth. In this example of mutually exclusive timing alternatives, an invest- ment decision based only on a simple economic rate of return computa- tion would have led to an erroneous choice. Beginning the project in 1970 would yield an overall economic rate of return from the project as a whole of 15 percent. Since this is well above the opportunity cost of capital, at first glance it might seem justifiable to proceed with the project. But we know from our first-year return analysis that if the project is begun in 1970 the return to the capital invested in the first year a positive benefit is received is only 8 percent, and it would thus be better to postpone the investment. Choosing the optimal starting year of 1975 means that the project will have an economic rate of return of 19 percent. If we postpone the project still further, we know that the present worth of the project at the opportunity cost of capital falls-but note that the simple economic rate of return to the project as a whole continues to rise, and this might be misleading to the unwary or ill-advised project analyst. The internal rate of return criterion can be manipulated to indicate the optimal timing by discounting the differences between the cash flows in each succeeding year until the internal rate of return to the incremental cash flow just equals the opportunity cost of capital. This calculation, however, is complex and more difficult to interpret than either the first-year return or the net present worth approach. In the Kenya example, the net benefit-investment ratio also indicates the optimal timing directly, but since the net benefit-investment ratio cannot in general be relied on to choose between mutually exclusive projects, its use to determine optimal timing is inadvisable. Choice between technologies (crossover discount rate) When there are technological alternatives by which we can realize the same result when designing a project, we have an instance of mutually Table 10-10. Determination of Optimal Timing, Third Highway Loan Project, Feeder Road Number 10, Kenya (thousands of K£) Incremental net benefit assuming construction to begin in: Year 1970 1971 1972 1973 1974 1975 1976 1977 1970 -380.0 - - - - - - 1971 -380.0 -380.0 - - - 1972 + 61.0 -380.0 -380.0 - - - - 1973 + 69 1 + 67.0 -380.0 -380.0 - - - 1974 + 77.7 + 75.3 + 73.0 -380.0 -380.0 - - 1975 + 84.7 + 847 + 82 7 + 79.7 -380.0 -380.0 - - 1976 + 923 + 92.3 + 92.3 + 89.7 + 86.4 -380.0 -380.0 - 1977 +100.6 +100.6 +100.6 +100.6 + 97.8 + 94.5 -380.0 -380.0 1978 +109.7 +109.7 +109.7 +109.7 +109.7 +1069 +102.6 -380.0 1979 +119.6 -+- 119.6 +119.6 +119.6 +119.6 +119.6 +116.0 +111.8 1980 + 130.3 + 130.3 + 130.3 + 130.3 + 130.3 + 130.3 + 130.3 + 126.4 1981 +1420 +142.0 +142.0 +142.0 +142.0 +142.0 +142.0 +142.0 1982 +154.8 +1548 +154.8 +154.8 +154.8 +154.8 +154.8 +154.8 1983 + 168.8 + 168.8 + 168.8 + 168.8 + 168.8 + 1688 + 168.8 + 168.8 1984 +183.9 +183.9 +183.9 +183.9 +183.9 +183.9 +183.9 +183.9 1985 +200.5 +2005 + 200.5 + 200.5 +200.5 +200.5 +200.5 +200.5 1986 +218.5 +218.5 +218.5 +218.5 +218.5 +2185 +218.5 +218.5 1987 +238.2 +238.2 +238.2 +238.2 +238.2 +238.2 +238.2 +238.2 1988 +259.7 +259.7 +259.7 +259.7 +259.7 +259.7 +259.7 +259.7 1989 +283.0 +283.0 +283.0 +283.0 +283.0 +283.0 +283.0 +283.0 1990 +308.5 +308.5 +308.5 +308.5 +308.5 +308.5 +308.5 +308.5 1991- 2000 +336.3 +336.3 + 336.3 +336.3 +336.3 +336.3 +336.3 +336.3 2001 +336.3 +361.6' +386.9b +412.2c +437.5d +462.8' +488.1' +513.4 Present worth at 12 percent +238.9 +262.2 +279.1 +290.8 +297.6 +300.6 +299.6 +295.4 First- year return (percent) 8 9 10 10 11 12 14 15 Economic rate of return (percent) 15 16 16 17 18 19 20 21 N/K ratio 1.31 1.35 1.37 1.38 1.39 1.40 1.39 1.39 Source: Adapted from World Bank, "Appraisal of a Third Highway Project, c. Includes residual value of K£75.9 thousand. Kenya," PTR-24a (Washington, D.C., 1969). Since this analysis was made, the d Includes residual value of KE101.2 thousand. unit of currency used in budgeting in Kenya has been changed from pounds to e. Includes residual value of K£126.5 thousand. shillings (KSh). f. Includes residual value of K£151.8 thousand a. Includes residual value of K£25.3 thousand. g. Includes residual value of K£177.1 thousand. b. Includes residual value of K£50.6 thousand. 386 MEASURES OF PROJECT WORTH exclusive alternatives because the choice of one technology precludes the use of another for the same purpose. The alternative we choose will be the one with the lower net present worth, but, if the total undiscounted cost of using the different alternatives is different and they have differing time profiles, the alternative we choose may depend on the opportunity cost of capital. Suppose we have a choice between two grain storage systems-one that uses silos and bulk handling and that has the lower undiscounted cost, and the other that uses warehouses and bags. The bulk handling system involves a high initial investment for silos but has low upkeep. The alternative system based on warehouses and bagging has a much lower construction cost but will entail substantial annual operating cost. At a low discount rate, the silo system with its high initial cost but low operating cost will have the lower net present worth-thus it would be preferred. At a high discount rate, however, the warehouse and bagging system with its low initial cost but high operating cost will have the lower net present worth. At some discount rate, both alternatives will have the same net present worth, and we will be indifferent on economic grounds which alternative we choose. This is known as the "crossover (or equalizing) discount rate," and it can be found either graphically or by discounting the differences between the cost streams. If the cost of capi- tal or cut-off rate is below the crossover discount rate, we will prefer the alternative that entails the higher initial capital outlay but lower ex- penditure in the future. Above the crossover discount rate, we will prefer the technological alternative with the lower initial cost, even though this involves higher operating cost later. We may illustrate this with a forestry project in Tunisia; the analysis is laid out in tables 10-11 through 10-13 and in figure 10-1. It was proposed to clear an area covered with maquis, a scrubby underbrush found in the Mediterranean region, at the rate of 400 hectares a year for five years to prepare the ground for reforestation. Two technological alternatives Table 10-11. Choice between Manual and Mechanical Land Clearing in Tunisia: Manual Clearing Alternative (US$) Present Present Project Other Total worth worth year Wagesa Costa cost 10% 15% 1 44,050 3,800 47,850 2 44,050 3,800 47,850 3 44,050 3,800 47,850 181,399 160,393 4 44,050 3,800 47,850 5 44,050 3,800 47,850 Total 220,250 19,000 239,250 181,399 160,393 US$ U.S. dollars. Source: Personal communication from Mr. Hans Warvinge, Swedish International De- velopment Authority (December 1971). a. All values at market prices. APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 387 Table 10-12. Choice between Manual and Mechanical Land Clearing in Tunisia: Mechanical Clearing Alternative (US$) Operation Present Present Project Equipment and Total worth worth year costa maintenancea cost 10% 15% 1 90,700b 21,586 112,286 102,068 97,689 2 0 25,134 25,134 20,761 19,001 3 0 25,134 25,134 18,876 16,538 4 0 26,227 26,227 17,913 15,002 5 0 26,227 26,227 16,287 13,035 Total 90,700 124,308 215,008 175,905 161,265 Source: Same as table 10-11. a. All values at market prices b. Tractor and clearer c.i.f. Tunis, taxes included. were available. The land could be cleared manually at a cost of US$47,850 per year spread evenly over the five-year period for an undis- counted total cost of US$239,250 (table 10-11). Alternatively, tractors and clearing equipment could be purchased and the area cleared me- chanically at a lower undiscounted total cost of US$215,008 (table 10- 12). The mechanical clearing alternative involved a large initial capital expenditure of US$90,700; after that, however, operation and mainte- nance costs would only be some US$25,000 a year. The proper choice between these two alternatives must allow for the time value of money. If a discount rate of 10 percent is assumed, we find the mechanical alternative continues to be cheaper and has the lower present worth. At 15 percent, however, we find the manual method has the lower present worth and, hence, costs less. If we subtract year by year the cost stream of the cheaper undiscounted alternative (in this case, the mechanical clearing) from the more expensive undiscounted alternative (the manual clearing) and then find the discount rate that brings the stream of the differences between the cost streams to zero, we will find that discount rate at which the present worths of the two alternatives are equal (hence, the term "equalizing discount rate"). From an economic standpoint, at this rate we are indifferent about the alternatives. As shown in table 10-13 for the Tunisian example, this crossover or equaliz- ing discount rate is 14 percent. (This discount rate may also be derived graphically as illustrated in figure 10-1.) If our opportunity cost of capital were 10 percent, we would prefer the mechanical clearing alternative, assuming that our criteria were based strictly on cost grounds. If the opportunity cost of capital were 15 percent, we would prefer the manual clearing alternative, even though this is the more expensive alternative in absolute (undiscounted) terms. If the opportunity cost of capital were 14 percent, on economic grounds we would be indifferent about the alternatives. In Tunisia, where the opportunity cost of capital was probably not much, if any, less than 14 percent, the manual alternative would doubt- 388 MEASURES OF PROJECT WORTH Table 10-13. Choice between Manual and Mechanical Land-clearing Alternatives in Tunisia: Crossover Discount Rate (US$) Differences Present Present Project between worth worth year cost streams 10% 15% 1 -64,436 -58,572 -56,059 2 +22,716 +18,763 +17,173 3 +22,716 +17,060 +14,947 4 +21,623 +14,769 +12,368 5 +21,623 +13,428 +10,747 Total + 24,242 + 5,448 - 824 Crossover discount rate = 10 + 5[5,448 - (5,448 + 824)] = 10 + 5(0.87) = 14 percent Source: Same as table 10-11. lessly be chosen if for no other reason than the employment effect manual clearing would have. Note, too, that the example uses market prices. If we were to shadow-price labor at 50 percent of its wage, the undis- counted cost of the manual clearing alternative falls to US$129,125 [(220,250 x 0.50) + 19,000 = 129,125], which makes it well below the undiscounted cost of the mechanical alternative even if we reduce the cost of the tractor and clearing equipment by the amount of duties and taxes. At the shadow wage, there would be no case at all for the mechani- cal alternative in this example. In other projects, however, the effect of the shadow wage would be to reduce the crossover discount rate- possibly to move it below a cut-off rate so that a labor-intensive alterna- tive that would not be attractive at market prices might prove to be the preferable alternative if shadow prices were used in the economic analysis. This Tunisian example shows vividly how low (perhaps subsidized) interest rates and high wages (perhaps the result of minimum wage regulations) can encourage mechanization and reduce employment. Additional purposes in multipurpose projects A variation of the problem of mutually exclusive alternatives arises in multipurpose projects. In these, a project design that includes one group of purposes is a mutually exclusive alternative to another project design that includes a different group of purposes. The problem is frequently met in rural development projects, and another common example is found in river basin development projects. The reason we are interested in multipurpose projects, of course, is that often it is possible to provide a group of related goods and services more cheaply from a single project than it is to provide the same benefits from the most economic, alternative single-purpose projects. But there is a danger that a very beneficial purpose (flood control, perhaps) may drive up the overall economic rate of return and thus hide another purpose (irrigation, perhaps) that should be omitted. APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 389 Figure 10-1. Graphic Derivation of Crossover Discount Rate, Choice between Mechanical and Manual Land-clearing Alternatives in Tunisia 185 180- Manual \ clearing alternative 175- 0 170- Mechanical clearing alternative 165- Crossover discount rate 10 11 12 13 14 15 Discount rate (percent) Source: Table 10-5. Projects may conveniently be tested for the desirability of an addi- tional purpose by determining the net present worth of the alternative groups of purposes at the opportunity cost of capital. If the project has a greater net present worth with an additional purpose than without it, then the additional purpose is justified. But if the net present worth is reduced by including an additional purpose, then obviously it would be undesirable to include the additional purpose in the project. The method of analysis is illustrated in tables 10-14 through 10-16. A multipurpose river basin project can be built to provide only flood con- trol and power benefits, or it can be expanded to include an irrigation component. The separable cost wholly attributable to each purpose is given in the first part of table 10-14. These indicate the extent to which the cost of the project would be reduced were one component omitted. In this instance, omitting irrigation reduces the cost of the project by US$18,965 thousand. The alternative cost of providing each benefit in the project by means of the most economic alternative single-purpose proj- 390 MEASURES OF PROJECT WORTH Table 10-14. Separable and Alternative Costs, Multipurpose River Basin Project, United States (thousands of US$) Project Flood Irriga- year control tion Power Separable cost 1 84 1,132 600 2 1,244 1,970 1,530 3 907 2,865 2,085 4-100 5 134 61 Total 2,720 18,965 10,132 Alternative cost 1 2,380 1,880 715 2 4,740 5,270 2,100 3 1,370 2,565 1,495 4-100 22 220 226 Total 10,624 31,055 26,232 Source: Adapted from U S. Government, Department of the Interior, Bureau of Reclama- tion, Reclamation Instruction Series 110, Prolect Planning (Washington, D.C., 1959), p. 116.5.19. ect is given in the second part of table 10-14. If the present worth of providing the same purpose by a single-purpose alternative were less than the present worth of the separable cost for providing that same purpose in the multipurpose project, there would be no grounds for including that purpose in the multipurpose project. In table 10-15, dis- counting at 2.5 percent (the rate in use at the time this analysis was done) shows that the net present worth of the project increases from US$8,273 thousand to US$10,935 thousand when the irrigation component is added. The investment decision, then, would be to include the irrigation component in the project. Had the net present worth with irrigation been less than US$8,273 thousand, the investment decision would have been to omit the irrigation component. The same investment decision would have been reached if the method of discounting the differences between the cash flows had been used, although this involves more calculation and more chance of error. This approach is illustrated in table 10-16. There the economic rate of return to the irrigation component is found to be 4 percent. Since this is greater than the opportunity cost of capital or cut-off rate of 2.5 percent, the investment decision would be to accept the irrigation component. Note, however, that if one were simply to calculate an internal rate of return for the two versions of the project, with irrigation and without irrigation, the version without irrigation has a slightly higher internal rate of return. If one were not careful about the method of analysis using the internal rate of return for mutually exclusive projects, the wrong investment decision might be made. (Note the relation between the net present worth analy- sis in table 10-15 and the analysis discounting the differences between cash flows in table 10-16. The differences of the net present worths of the cash flows discounted at 2.5 percent in table 10-15 is US$2,662 thousand APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 391 Table 10-15. Measures of Project Worth without and with Irrigation, U.S. Multipurpose River Basin Project (thousands of US$) Benefit Incremental Discount Present Project Flood Irriga- net benefit factor worth year Cost control tion Power (cash flow) 2.5% 2.5% Without irrigation 1 2,456 - - - - 2,456 0.976 - 2,397 2 6,218 - - - - 6,218 0.952 - 5,920 3 1,983 - - - - 1,983 0.929 - 1,842 4-100 72 271 - 347' 546 33758 +18,432 Total 17,641 26,287 - 33,659 +42,305 36.615 + 8,273 Net present worth at 2.5 percent without irrigation = US$+8,273 Internal rate of return without irrigation = 4.8 percentb N/K ratio at 2.5 percent without irrigation = US$18,432 - US$10,159 = 1.81b With irrigation 1 3,588 - - - - 3,588 0.976 - 3,502 2 8,188 - - - - 8,188 0.952 - 7,795 3 4,848 - - - - 4,848 0.929 - 4,504 4-100 206 271 380 347" + 792 33.758 +26,736 Total 36,606 26,287 36,860 33,659 60,200 36.615 + 10,935 Net present worth at 2.5 percent with irrigation = US$+ 10,935 Internal rate of return with irrigation = 4.5 percentb N/K ratio at 2.5 percent with irrigation = US$26,736 - US$15,801 = 1.69b Source: Same as table 10-14. a. See the text for a discussion about valuing the power benefit. b. See the text for a discussion about interpreting these measures. (10,935 - 8,273 = 2,662), which is exactly the net present worth of the differences of the streams of cash flows discounted at 2.5 percent as shown in table 10-16.) For illustrative purposes, the net benefit-investment ratio has been included in table 10-15. Note that the net benefit-investment ratio with- out irrigation, 1.81, is larger than the net benefit-investment ratio with irrigation, 1.69. Once again we find that the net benefit-investment ratio cannot be relied on to choose between mutually exclusive alternatives. A complication arises in regard to the benefit of the power component. The economic benefit of electricity is generally considered not possible to estimate. What is the benefit of electricity, especially if much of it goes for household use? In economic analysis of single-purpose projects, this difficulty is usually resolved by assuming that alternative projects gener- ating the same amount of electricity will have an equivalent benefit and by simply choosing the one for which the present worth of the cost is lowest. In analyzing projects such as this multipurpose one, however, a different approach to valuing power is conveniently adopted. It may be assumed that if power consumers are willing to pay the price that would have to be charged to provide the same amount of electricity by the most economic single purpose as indicated in the second part of table 10-14, then the economic value of the power component in the multipurpose Table 10-16. Discounting Differences between Cash Flows, With and Without Irrigation, U.S. Multipurpose River Basin Project (thousands of US$) Incremental Incremental net benefit net benefit (cash flow) (cash flow) Differences Discount Present Discount Present Project with without between factor worth factor worth year trrigation irrtgatton cash flows 2.5% 2.5% 5% 5% 1 - 3,588 - 2,456 - 1,132 0.976 - 1,105 0.952 -1,078 2 - 8,188 - 6,218 - 1,970 0.952 -1,875 0.907 -1,787 3 - 4,848 - 1,983 - 2,865 0.929 -2,662 0.864 -2,475 4-100 + 792 + 546 + 2461 33.758 +8,304 17.125 +4,213 Total +60,200 +42,305 +17,895 36615 +2,662 19.848 -1,127 Internal rate of return of irrigation component = 2.5 + 2.5(2,662 - 3,789) = 4 percentb Source: Same as table 10-14. a. See the text for a discussion about valuing the power benefit b. See the text for a discussion about interpreting this measure. APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 393 project is at least that much. That being the case, we may take the annual benefit of the power to be at least the annual equivalent of the net present worth of the cost of providing the power by means of the most economic single-purpose alternative. In this instance, if we discount the stream of costs for the most eco- nomic single-purpose power alternative as given in the second part of table 10-14 at the opportunity cost of capital of 2.5 percent, we reach a net present worth of US$11,715 thousand. To convert this net present worth to an annual equivalent, we need the capital recovery factor for the period from the 4th through the 100th year of the project, since power from the single-purpose alternative is assumed to begin to flow in the 4th year. This cannot be determined conveniently from a commonly used set of compounding and discounting tables such as those in Gittinger (1973). We can, however, calculate the capital recovery factor directly by deter- mining the present worth of an annuity factor for the 4th through the 100th years and by then taking the reciprocal of that, since the capital recovery factor is the reciprocal of the present worth of an annuity factor. (This method is discussed in more detail in the section on "Joint Cost Allocation" in chapter 6.) The present worth of an annuity factor at 2.5 percent for 100 years is 36.614 105. This may be obtained from a detailed set of compounding tables, from calculation along the lines of the discus- sion in the last section of this chapter, or from the formula in appendix B. The present worth of an annuity factor for 2.5 percent for 3 years is 2.856 024, so that the present worth of an annuity factor at 2.5 percent for the 4th through the 100th years is 33.758 081 (36.614 105 - 2.856 024 = 33.758 081). The capital recovery factor for the 4th through the 100th years at 2.5 percent can then be obtained by taking the reciprocal of the present worth of an annuity factor, or 0.029 623 (1 + 33.758 081 = 0.029 623). We then apply that factor to the net present worth at 2.5 percent of the stream of costs of providing the power by the most economic single- purpose alternative, US$11,715. The result is the annual value of the cost of providing the power by the single-purpose alternative, US$347 thousand (11,715 x 0.029 623 = 347). This value can then be used to estimate the present worth of the multipurpose project with and without the irrigation component. A fuller discussion of valuing electricity will be found in van der Tak (1969). Applying Contingency Allowances For many estimates of project costs, especially costs of those projects in which there is a considerable element of construction in the earlier years, the engineers will often include a contingency allowance. We noted in chapter 2 that physical contingency allowances and contingency allow- ances intended to reflect relative price changes are real costs in both financial and economic analysis and should be incorporated directly into the project accounts even when the analyst is working in constant prices. The contingency allowance intended to allow for general inflation, 394 MEASURES OF PROJECT WORTH however, does not enter into the project accounts, either financial or economic, when the analyst is working in constant prices. This means that when inflation is expected to be significant, a separate financing plan will be needed to give those responsible for making budget alloca- tions a better idea of the amounts in current terms that they will be asked to make available. Because future price increases can affect costs only until work is com- pleted, the overall contingency allowance for inflation is built up by applying the appropriate compounding factors to the amount to be expended each year. Suppose we take a project with an expected total cost of US$390 thousand in constant terms as of the beginning of the project, or to. Construction costs are to be incurred equally each year over a three-year construction period. We expect inflation to be 8 percent a year during construction. We can lay out the computation as follows (costs are in thousands of U.S. dollars): Project cost Compounding Project cost in constant factor for 1 in current Year terms at 8 percent terms 1 130 x 1 080 = 140 2 130 x 1.166 = 152 3 130 x 1.260 164 Total 390 456 The total cost for the project in current terms would thus be US$456 thousand, and the price contingency would be 17 percent [(456 - 390) + 390 x 100 = 17]. This, of course, is quite different from the 26 percent price contingency we would obtain if we were to compound the whole project cost in constant terms over the three-year period [390 x 1.260 = 491; (491 - 390) + 390 x 100 = 26]. Contingency allowances are usually not included for the operating costs of a project once the initial investment stage is passed. Rather, problems such as higher than anticipated production expenditures are customarily analyzed by using sensitivity analysis, and a judgment is then made about whether to change the design of the project or to abandon it. In agricultural credit projects, it is generally not necessary to include contingency allowances. Changes in unit costs for this kind of project will primarily affect the number of loans that can be made with the funds available rather than the economic justification of the project itself. Contingencies in agricultural credit projects usually will, however, be treated in the discussion of the economic justification of the project, perhaps in conjunction with the sensitivity analysis. Contingency allowances are best shown separately in project tables, with appropriate explanations of how they were calculated included in the accompanying text and notes. To avoid double counting, any contin- gency allowances already included in the basic material used to prepare the project analysis should be eliminated. The amount of contingency provision will vary with the nature of the project and the general compo- nents of the project. Contingency allowances should be determined item APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 395 by item for each project, not based on some national standard allowance. In general, contingency allowances should not be large enough to cover almost any cost overrun, since the possibility of so large a change occur- ring is small. Such excessive prudence will reduce the pressure for care- ful cost estimation, relax pressure for tight cost control during project execution, and result in misleading underestimates of the net present worth, the financial and economic return, or the net benefit-investment ratio. Physical contingency allowances usually are estimated separately for each major category of cost and separately for local and foreign exchange costs. Projects that include large civil engineering works require higher contingency allowances than projects that cover only the supply and erection of equipment. The cost of engineering works will be influenced by such factors as the topography and geology of the project area, the amount of field work necessary to prepare the detailed designs, unfore- seen technical difficulties (especially if the project involves subsurface work), the risk of underestimating the amount of work actually required, changes in design during construction, and unusually bad weather that may interrupt work. If large amounts of equipment are involved, con- tingencies may be appropriate to allow for errors in estimating the exact amount'of equipment and the quantity of spare parts needed. Contingency allowances for relative price changes during the early investment phase of a project may reflect anticipated influences arising from domestic price increases, the expected trend of prices in leading supplier countries, price trends for particular kinds of work or kinds of equipment to be used, and the possible effect of the project in exerting a strong upward pull on prices of locally supplied labor and raw materials. [A projected index of international inflation is included in Price Prospects for Major Primary Commodities (World Bank 1982a), which may be help- ful in estimating price trends in supplier countries and for imported equipment.] Replacement costs Many agricultural projects require investments that have different lifetimes. A good example is found in the case of a pump irrigation scheme in which the earthworks and pump platforms may be expected to last twenty-five to fifty years but the pumps themselves may have a life of only seven to fifteen years. In preparing the analysis, allowance must be made for the replacement cost of the pumps during the life of the project. Treatment of replacement costs is simple. The analyst includes them among the capital items for the appropriate year in the project analysis. In analysis of the net present worth, internal rate of return, and net benefit-investment ratio, the replacement costs are then netted out when the cash flow is computed. This may make the cash flow for that particu- lar year negative, but only rarely in an agricultural project could this introduce analytical complications (see the subsection on "More than one possible internal rate of return" in chapter 9). Table 10-17. Treatment of Replacement Cost, Lift Irrigation Project, India (thousand of Rs) Invest- Incre- Incremental Discount Present Discount Present Discount Present Project ment mental net benefit factor worth factor worth factor worth year cost benefit' (cash flow) 12% 12% 30% 30% 35% 35% 1 469 0 - 469 0893 - 419 0.769 -361 0.741 -348 2 223 0 - 223 0.797 - 178 0.592 - 132 0.549 -122 3 0 155 + 155 0.712 + 110 0.455 + 71 0406 + 63 4-8 0 310 + 310 2.566 + 795 1.109 +344 0.902 +280 9 223" 310 + 87 0361 + 31 0.094 + 8 0.067 + 6 10-15 0 310 + 310 1.483 + 460 0.249 + 77 0.160 + 50 16 223b 310 + 87 0.163 + 14 0.015 + 1 0.008 + I 17-22 0 310 + 310 0.671 + 208 0.040 + 12 0019 + 6 23 223" 310 + 87 0.074 + 6 0.002 0 0.001 0 24 0 310 + 310 0.066 + 20 0.002 + 1 0.001 0 25 0 469' + 469 0.059 + 28 0.001 0 0.001 0 Total 1,361 7,134 +5,773 7.845 +1,075 3.328 + 21 2.855 - 64 Net present worth at 12 percent = Rs+ 1,075 Finanicial rate of return = 30 + 5[21 - (21 + 64)] = 30 + 5(0.25) = 31 percent N/K ratio = Rsl,672 - Rs597 = 2.80 Rs Indian rupees. maintenance of the scheme are recovered by charges to farmers and are Source: Adapted from "Report on Lift Irrigation Project in Sangli District, deducted from gross output as a production cost. Maharashtra," section 18 of Selected Agricultural Project Reports (Pune, Maha- b. Pump replacement. rashtra: College of Agricultural Banking, 1978), pp. 373-92. c. Includes residual value for pumps of Rsl59 thousand; civil works are a. The incremental benefit is aggregated from farm budgets. Operation and assumed to have no residual value. APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 397 The treatment of replacement costs is illustrated in table 10-17. The project is a lift irrigation scheme proposed for Sangli District in the state of Maharashtra in western India. The scheme would draw water from the Krishna River to serve three villages and would enable the farmers to grow hybrid sorghum, wheat, and sugarcane in addition to their tradi- tional, rainfed crops. The project would take two years to complete. Once in operation, the civil works associated with the pumps could be ex- pected to last at least twenty-five years. The pumps themselves, however, are expected to be replaced every seven years. In table 10-17, the invest- ment column shows Rs223 thousand for pump replacement in years 9, 16, and 23. The project thus allows for pump replacement quite directly by simply including replacement as an investment cost in the years it is expected to occur. (Note that there is a "residual" value to allow for the unexpired life of the last pump cycle in year 25; we will return to this in the next subsection.) In this Indian example (as is generally the case), the investment cost for pump replacement is not large enough to turn the cash flow negative in any year when new pumps are to be installed, so there is no possibility that there will be more than one solution when the internal rate of return is calculated. Residual value Often at the end of a project there may reasonably be expected to be some residual (or terminal) value. That is, the capital asset will not have been all used up in the course of the project period, and there will be a "residual asset." The way to handle this is to treat the residual value of any capital item (say a dam or a stand of trees) as a project "benefit" during the last year of the analysis period. An example of a residual value is found in the analysis of the Indian pump project outlined in table 10-17 and discussed in the previous subsection on replacement costs. The pumps in this project are replaced every seven years. The last pump replacement before the end of the project in year 25 occurs at the end of year 23. The pump, therefore, is expected to have been used for only two years of its seven-year life by the end of the project. The value of the remaining useful life of the pump should not properly be charged as an investment cost to the project; instead, the project should be credited with the residual value in the final year of the project. Thus, in this example the analyst added an amount equal to five-sevenths of the Rs223 thousand investment cost included in year 23 to the incremental benefit in year 25, or Rsl59 thousand [(7 - 2) + 7 x 223 = 159]. On the whole, residual values will not change the net present worth, rate of return, or net benefit-investment ratio significantly unless the period of the analysis is short or the value of the capital items is quite large in relation to the value of the benefit stream. Such might be the case, for instance, in a livestock project in which a very large residual value may build up in the form of a valuable herd. For agricultural projects carried out to 25 years or so, however, the residual value will 398 MEASURES OF PROJECT WORHI usually not change the net present worth or the net benefit-investment ratio by more than a very small proportion, or the rate of return by as much as a percentage point. The reasons are the same ones noted in the discussion of the length of the project period. At the earning capacities of the kinds of projects we are considering, the present worth of future benefits (hence, the present worth of residual values) is just not very great. A practical result of this is that projects are quite insensitive to errors in estimating residual values. A rather gross estimate in a twenty- five-year project is adequate. Note that in table 10-17 virtually no error in estimating the salvage value could significantly affect the measures of project worth. Including residual values in the project analysis will forestall criticisms of the project analysis, or attempts to discredit a project with a low initial investment in favor of another with a high initial investment on the grounds that the analyst ignored the residual value. This may be important when discussing irrigation projects or livestock projects because the technicians' concern and attention may be largely focused on the problems associated with the capital investment in the dam or in the buildup of the breeding herd. Domestic resource cost In countries where there are balance of payments problems and where import substitution or export promotion is an important objective, it is useful to estimate the cost in the domestic currency required to earn a unit of foreign exchange through a proposed project. The usefulness of doing so might arise, for instance, in preparing an oil palm project in which export or avoidance of vegetable oil imports is the objective or in evaluating a fertilizer plant intended to reduce or avoid future increases in imports. It is not enough just to earn or save foreign exchange. Some idea must be formed of the cost of saving foreign exchange, and a judg- ment must be made about whether that cost is too high. By expressing the cost of earning or saving a unit of foreign exchange as domestic resource cost, a direct comparison may be made with the official ex- change rate and various shadow prices for foreign exchange. Such a comparison is one basis for evaluating a project. There are many approaches to estimating the domestic resource cost and numerous theoretical problems to be resolved. These have been discussed at length by Bruno (1967), whose name is so closely identified with this topic that the domestic resource cost is often called the Bruno ratio. Tables 10-18 and 10-19 illustrate a straightforward approach to esti- mating the domestic resource cost. This approach is suitable for most project purposes. Its major limitations are the tendency for some "domestic" costs to involve imports-the import consumption of work- ers, for example-and the partial analysis problem that is common to all discounted measures of project worth. Its advantages are its simplicity and the ease with which the result may be interpreted. To calculate the domestic resource cost by this method, it is necessary to know four items: APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 399 Table 10-18. Calculation of Domestic Resource Cost, Indian Farmers Fertilizer Cooperative Fertilizer Project, India: Foreign Exchange Component (millions of US$) Value of Invest- Produc- Other Incre- Discount Present produc- ment tion cost or mental factor worth Year tion cost cost savinga saving 12% 12% 1970 - 7 - - - 7 0.893 - 6 1971 - 15 - - - 15 0.797 -12 1972 - 15 - - - 15 0.712 - 11 1973 12 - 12 - 0 0.636 0 1974 38 - 18 - + 20 0.567 +11 1975 43 - 20 - + 23 0.507 +12 1976 56 - 26 - + 30 0.452 +14 1977 56 - 25 - + 31 0.404 +13 1978 56 - 25 - + 31 0.361 + 11 1979-84 56 - 25 - + 31 1.483 +46 Total 597 37 276 - +284 6.812 +78 Source: Adapted from U.S. Government, U.S. Agency for International Development (USAID), "India: IFFCO Fertilizer Project Proposal and Recommendations for the Review of the Development Loan Committee," AID-DLC/P-851 (Washington, D.C., 1969), annexes 4A and 4B. a. If applicable, would include such differences in cost or saving as foreign exchange for insurance, domestic currency saving in distribution from avoiding port charges and locat- ing production closer to the point of use, and the like. Table 10-19. Calculation of Domestic Resource Cost, India Fertilizer Project: Domestic Currency Component (millions of Rs) Invest- Produc- Other Incre- Discount Present ment tion cost or mental factor worth Year cost cost savinga cost 12% 12% 1970 107 - - 107 0.893 96 1971 172 - - 172 0.797 137 1972 56 - - 56 0.712 40 1973 24 38 - 62 0.636 39 1974 - 81 - 81 0.567 46 1975 - 90 - 90 0.507 46 1976 - 109 - 109 0.452 49 1977 - 109 - 109 0.404 44 1978 - 109 - 109 0.361 39 1979-84 - 108 - 108 1.483 160 Total 359 1,184 - 1,543 6.812 696 Domestic Present worth of domestic currency cost resource _ of realizing foreign exchange saving - Rs696 - US$78 = 8.92 cost Present worth of net foreign exchange savingb Source: Same as table 10-18. a. If applicable, would include such differences in cost or saving as foreign exchange for insurance, domestic currency saving in distribution from avoiding port charges and locat- ing production closer to the point of use, and the like. b. From table 10-18. 400 MEASURES OF PROJECT WORTH (1) the foreign exchange value of the product to be produced; (2) the foreign exchange cost incurred to produce the product (that is, the for- eign exchange cost of such things as imported fuels, imported raw mate- rials, and the like); (3) the domestic currency cost of producing the output; and (4) the opportunity cost of capital. The present worth of the net foreign exchange benefit (discounted at the opportunity cost of capi- tal) is compared with the present worth of the domestic cost of realizing these savings. The ratio between the two present worths is the domestic resource cost, and it may be directly compared with the official exchange rate or with shadow exchange rates. The Indian Farmers Fertilizer Cooperative, Ltd., proposed to build a modern petrochemical fertilizer facility in the state of Gujarat. The economic analysis gives the costs and benefits broken down into their foreign exchange (table 10-18) and domestic currency (table 10-19) com- ponents. The domestic resource cost with a 12 percent opportunity cost of capital assumed is Rs8.92 = US$1. Since the official exchange rate at the time of the analysis was Rs7.50 US$1, if the official exchange rate is accepted as a true measure of the value of the rupee (and 12 percent is accepted as the opportunity cost of capital), then it would cost more to manufacture through the project a dollar's worth of fertilizer for import substitution than it would to buy the fertilizer from abroad. At the time the analysis was undertaken, however, it was widely considered in India that a foreign exchange premium of at least 25 percent would better reflect the true value of the rupee. This would make the shadow exchange rate Rs9.375 = US$1 (7.50 x 1.25 = 9.375). If this rate is accepted (with 12 percent still the oppor- tunity cost of capital), then it would cost less to produce a dollar's worth of fertilizer than to import it because the domestic resource cost of Rs8.92 = US$1 is a more favorable exchange rate than the shadow exchange rate of Rs9.375 = US$1. Calculating Measures of Project Worth Using Current Prices We have often noted that project analyses are usually done at constant prices because the analyst is concerned with the real return to the project when he is looking at the financial analysis and with the real, not mone- tary, effects of the project when he turns to economic analysis. Thus, it is common practice for the analyst to assume that general inflation will exert the same relative effect on both costs and benefits and to work in constant prices. Projects can, of course, be analyzed using current prices. If that were done, general inflation would not affect the selection of projects provided that all projects were analyzed using the same assumptions. That is, the same group of projects would be accepted whether the analysis is done on a constant price basis or on a current price basis. Working with constant APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 401 prices, however, is the analytically simpler approach because it avoids estimating a rate of inflation and simplifies the computations. If we use net present worth as the measure of project worth, the amount of the net present worth will be different depending on whether we use current or constant prices (and also on whether we use a shadow foreign exchange rate or a conversion factor to allow for the foreign exchange premium). If we estimate the opportunity cost of capital for the analysis correctly, we will still select the same group of projects to implement. The opportunity cost of capital, however, will be higher by an allowance for inflation. If we use net present worth, we may assume a different rate for inflation for each year if that suits our analytical pur- pose. There is no easy means to compare the net present worth at current prices to the net present worth at constant prices; the present worth computation must be repeated for each stream of values, and all projects being analyzed must use the same assumptions. A similar comment holds for the net benefit-investment ratio. The value of the ratio will change with changing assumptions about inflation and there is no easy way to compare the net benefit-investment ratio at current prices to the net benefit-investment ratio at constant prices. In contrast, an internal rate of return calculated at current prices, with a uniform general inflation rate assumed, can easily be converted to the rate of return at constant prices by dividing 1 plus the internal rate of return stated in decimal terms for the current prices by I plus the rate of inflation stated in decimal terms. This is illustrated in table 10-20 with the figures from the Ilocos, Philippines irrigation project that were given in table 9-11. If we assume constant prices, the economic rate of return is 18 percent. If we assume a uniform inflation rate of 6 percent throughout the life of the project, then we can derive the incremental net benefit (cash flow) in current prices for any given year by multiplying the in- cremental net benefit (cash flow) in constant prices for that year by the appropriate compounding factor for I at 6 percent. If we determine the internal rate of return for the resulting incremental net benefit (cash flow) stream, we find it to be 25 percent. Dividing this result (in the form of 1 plus the internal rate of return stated in decimal terms) by the assumed inflation rate (also stated in the form of I plus the inflation rate stated in decimal terms) gives 1.18-or the economic rate of return of 18 percent we found using constant prices (1.25 + 1.06 = 1.18). Calculator Applications in Project Analysis We noted earlier that calculations for project analysis are simply too tedious to be done by hand; however, even the simplest electronic calcu- lators readily available in virtually every nation are sufficient for nearly all calculations needed in project analysis. Indeed, they are the basic computational aid used both by national planning agencies and by inter- national lending institutions. Unfortunately, many project analysts do Table 10-20. Internal Rate of Return Computation Using Current Prices, Ilocos Irrigation Systems Improvement Project, Philippines (millions of US$) Incremental Com- Incremental net benefit pounding net benefit (cash flow) Discount Present factor (cash flow) Discount Present Discount Present Project at constant factor worth for I at current factor worth factor worth year prices' 18%a 18% at 6% pricesb 25% 25% 30% 30% 1 - 1.09 0.847 -0.92 1.060 - 1.16 0.800 -0.93 0.769 -0.89 2 - 4.83 0.718 -3.47 1 124 - 5.43 0.640 -3.48 0.592 -3.21 3 - 5.68 0.609 -3.46 1.191 - 6.76 0.512 -3.46 0.455 -3.08 4 - 4.50 0.516 -2.32 1.262 - 5.68 0.410 -2.33 0.350 -1.99 5 - 1.99 0.437 -087 1.338 - 2.66 0.328 -0.87 0.269 -0.72 6 + 1.00 0.370 +0.37 1 419 + 1.42 0.262 +0.37 0.207 +0.29 7 + 2.37 0.314 +0.74 1.504 + 3.56 0.210 +0.75 0.159 +0.57 8 + 3.70 0.266 +0.98 1.594 + 5.90 0.168 +0.99 0.123 +0.73 9 + 506 0.225 +1.14 1.689 + 8.55 0.134 +1.15 0.094 +0.80 10 + 6.43 0.191 +1.23 1.791 + 11.52 0.107 +1.23 0.073 +0.84 11 + 6.43 0.162 +1.04 1.898 + 12.20 0.086 +1.05 0.056 +0.68 12 + 6.43 0 137 +0.88 2.012 + 12.94 0.069 +0.89 0.043 +0.56 13 + 6.43 0.116 +0.75 2.133 + 13.72 0.055 +0.75 0.033 +0.45 14 + 6.43 0.099 +0.64 2.261 + 14.54 0.044 +0.64 0.025 +0.36 15 + 6.43 0.084 +0.54 2.397 + 15.41 0.035 +0.54 0.020 +0.31 16 + 6.43 0.071 +0.46 2.540 + 16.33 0.028 +0.46 0.015 +0.24 17 + 6.43 0.060 +0.39 2.693 + 17.32 0.023 +0.40 0.012 +0.21 18 + 6.43 0.051 +0.33 2.854 + 18.35 0.018 +0.33 0.009 +0.17 19 + 6.43 0.043 +0.28 3.026 + 19.46 0.014 +0.27 0.007 +0.14 20 + 6.43 0.037 +0.24 3.207 + 20.62 0.012 +0.25 0.005 +0.10 21 + 6.43 .0.031 +0.20 3.400 + 21.86 0.009 +0.20 0.004 +0.09 22 + 6.43 0.026 +0.17 3.604 + 23.17 0.007 +0.16 0.003 +0.07 23 + 6.43 0.022 +0.14 3.820 + 24.56 0.006 +0.15 0.002 +0.05 24 + 6.43 0.019 +0.12 4.049 + 26.04 0.005 +0.13 0.002 +0.05 25 + 6.43 0.016 +0.10 4.292 + 27.60 0.004 +0.11 0.001 +0.03 26 + 6.43 0.014 +0.09 4.549 + 29.25 0.003 +0.09 0.001 +0.03 27 + 6.43 0.011 +0.07 4.822 + 31.01 0.002 +0.06 0.001 +0.03 28 + 6.43 0.010 +0.06 5.112 + 32.87 0.002 +0.07 0.001 +0.03 29 + 6.43 0.008 +0.05 5.418 + 34.84 0.002 +0.07 0.000 +0 30 + 6.43 0.007 +0.05 5.743 + 36.93 0.001 +0.04 0.000 +0 Total +129.07 5.517 +0.02 +458.28 3.996 +0.08 3.331 -3.06 Internal rate of return (economic rate of return) at current prices = 25 + 5(0.08 - 3.16) = 25.13 = 25 percent Internal rate of return (economic rate of return) at constant prices = 1.2513 - 1.06 = 1.1805 = 18 percent Source: Adapted from World Bank, "Philippines: Appraisal of the National a. See table 9-12. Irrigation Systems Improvement Project: i," 1488a (Washington, D.C., 1977; b. An inflation rate of 6 percent is assumed. restricted circulation), annex 20, tables 2 and 6. 404 MEASURES OF PROJECT WORTH not take full advantage of the flexibility that even simple calculators offer. We will illustrate some of the uses of a calculator in this section. For this purpose we will provide illustrative computations based on a widely sold, inexpensive calculator (see photograph), but the reader should note that calculators do vary in their opera- tion and that these illustrations will probably have to be adapted. The calcu- lator on which this discussion is based has an eight-digit display (indicated by the display window in the photograph). It can perform the four arithmetic func- tions of addition, subtraction, multi- plication, and division. It has one fully addressable memory; that is, one may add to the memory, subtract from the memory, and recall the memory to the display. The calculator can multiply or divide repeatedly by a constant and can ___________- perform chain computations. (Although the small calculators generally avail able are quite accurate, the last two________ places when the display is fully used fol- lowing multiplication or division can- not be accepted with confidence. All the digits reproduced in the com- putations below are correct because they have been verified with more elaborate equipment; when the reader follows these illustrations on his own calculator, he may find occasions when the final digit or two do not agree with those given here.) In these illustrations, numbers reproduced in ordinary roman type are pressed and entered on the calculator as indicated. Numbers printed in italic type will be displayed automatically and do not need to be entered. An arithmetic sign or a function notation in boldface type indicates that this key (button) on the calculator is to be pressed in the order shown. Thus, a 2 indicates a number to be entered and a + indicates that the plus button should be pressed. Other notations include M. for "add to memory"; M- for "subtract from memory"; R-CM for "recall memory" when pressed once and "clear memory" when pushed a second time; and ON/C for turning the machine on and for clearing the display. We can illustrate the arithmetic and chain calculations quickly and simply. Recall the example about calculating the economic value of a tractor in chapter 7 (the subsection "Adjusting Financial Prices to Eco- nomic Values. Indirectly traded items"). We discussed the various com- putations needed to go from a market price to an economic value. We were told that in a tractor costing Rs65,000, 30 percent of the cost was for domestic components and 70 percent of the cost was for imported com- ponents. There was a tariff of 15 percent, so the amount of the imported component had to be divided by 1.15 to eliminate the tariff. We wanted to shadow-price the imported component by using a shadow exchange rate APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 405 of Rsl2 = US$1 instead of the official exchange rate of Rs10 = US$1, and this meant that we increased the domestic price of the imported compo- nent by the foreign exchange premium of 20 percent, or 1.2 stated in decimal terms.,Each step was set forth individually, but we could have combined all the computations into one chain calculation: R-CM R-CM 65,000 x 0.3 Mi 19,500 65,000 x 0.7 + 1.15 x 1.2 M- 47,478 R-CM 66,978. The last figure is, of course, the amount we derived when we added the individually calculated portions together. One very convenient use of a simple calculator is to verify budget tables quickly. In the Paraguay farm budget in table 4-19, during the fourth year the total inflow was Q426.6 thousand and the total outflow was Q129.3 thousand, and these gave a net benefit before financing of (297.3 thousand. From this was subtracted debt service of 098.2 thousand to obtain the net benefit after financing of Q 199.1 thousand. We can quickly check these totals by simply entering the individual inflow and outflow entries in order on the calculator: R-CM R-CM 340.7 + 85.9 M+ 426.6 13.4 + 112.8 + 3.1 M- 129.3 R-CM 297.3 ON/C - 98.2 M+ - 98.2 R-CM 199.1. The use of the constant feature of the calculator is convenient when we have several values we wish to change by some common proportion. In the calculator we are using for illustration, the constant feature is acti- vated after multiplication and division simply by entering a new number and pressing the = button, but on many calculators the constant feature is activated by pressing the "arithmetic" button twice before pressing the = button. An example of when the use of a constant would be conve- nient is found in table 7-1, in which we wished to convert all dollar values to their rupee equivalents using a shadow exchange rate. We have dollar values of US$175, US$20, and US$9. The shadow exchange rate is Rsl2 = US$1: R-CM R-CM 12 x 175 = 2,100 20 = 240 9 = 108. One use of even a simple calculator that also takes advantage of the constant feature is to derive the factors for financial computations or for discounting. Suppose we want to find the compounding factor for 1 for 14 percent at the end of five years: 1.14 x 1 = = = = = 1.925 414 6. We can verify this by checking in a standard set of tables such as Com- pounding and Discounting Tables for Project Evaluation (Gittinger 1973). Note that in laying out the computation as indicated the = button is 406 MEASURES OF PROJECT WORTH pressed as many times as the number of years to be calculated, in this case five. Discount factors can be just as easily calculated. Since we know that the discount factor is the reciprocal of the compounding factor for 1, we could find the discount factor for 14 percent for five years by dividing 1 by 1.925 415 to obtain 0.519 369. We could reach this result more directly by using our calculator to divide I repeatedly by 1 plus our discount rate to obtain the discount factor for 14 percent for five years: 1.14 - = = = = = 0.519 368 7. Again, we may verify this by checking in the tables or, to the nearest third decimal, in compounding and discounting table 6 in appendix B. Since the present worth of an annuity factor is the running subtotal of the discount factors, we may obtain it by adding together all the discount factors as we compute them. On the least expensive calculators, there may be an accumulating memory that makes this very easy. On the somewhat more complicated calculators with fully addressable memo- ries in which the M+ activates the constant feature, the computation is also simple. But on the calculator we are using for illustrative purposes, a bit more manipulation is required. Suppose we want the present worth of an annuity factor for 14 percent for five years: R-CM R-CM 1.14 - = M+ = M+ = M* = M+ = M- R-CM 3.433 081 0. Finally, we may compute the capital recovery factor easily if we recall that it is the reciprocal of the present worth of an annuity factor. Since we have already obtained the present worth of an annuity factor for 14 percent for five years, we could simply divide 1 by 3.433 081 to obtain 0.291 284. We could compute this directly, however: R-CM R-CM 1.14 - = M+ = M+ = M+ = M+ M- R-CM + = 0.291 283 5. For project analysis, the ease with which we can compute discount factors using a simple calculator is most significant when we have occa- sion to use a fractional discount rate. Some standard discounting tables (including Gittinger 1973) do not have fractional intervals, and those which do generally do not have them for higher interest rates. Using a simple calculator, however, we can easily compute our own factors if, for example, we want to calculate a present worth at some fractional dis- count rate. In agricultural projects, one use of the calculator to derive factors occurs when we are working out debt service estimates in farm budgets where the credit terms involve fractional interest rates. In the India Cashewnut Project used to illustrate unit activity budgets in chapter 4, tables 4-22 and 4-25, farmers could borrow at 10.5 percent interest to finance tree planting and then repay in six equal annual installments. To calculate the annual payment for years 8 through 13, we need the capital APPLYING DISCOUNTED MEASURES OF PROJECT WORTH 407 recovery factor for 10.5 percent for six years. We are unlikely to be able to find the factor in a standard discounting table, but we can easily obtain it directly by using our calculator: R-CM R-CM 1.105 - = M+ = M+ = M+. = M+ = M+ = M+ R-CM + = 0.232 981 9. Without a fractional discounting table, we cannot verify our result directly, but we can check to make sure it is of the right order of magni- tude by comparing it with the capital recovery factor for six years for 10 percent and for 11 percent. For 10 percent the value is 0.229 607; for 11 percent it is 0.236 377. Our capital recovery factor lies roughly halfway between these two values (although not exactly so, of course), so we may be confident that our factor is pretty close to correct. Now, we may multiply the loan principal (including capitalized interest) of Rs4,756 by our factor of 0.232 981 9 to obtain the annual payment of Rs1,108 (4,756 x 0.232 981 9 = 1,108). This, then, is the amount shown for debt service in years 8 through 13 in tables 4-22 and 4-25. The various factors used in project analysis may also be computed directly quite easily if one has a calculator that can compute powers. (The simple one we have been using for illustration cannot.) Usually this is indicated by a key marked with xy or some similar notation. If we return to the example from the Indian credit project noted above, we may illustrate how to calculate directly the capital recovery factor for 10.5 percent for seven years. The formula for the capital recovery factor (given in appendix B) is: i(l + i)n (1 + i)" - For convenience, we will begin by calculating the denominator first and then put it into the memory. It is also convenient to begin our calculations by determining the value of (1 + i)" and then subtracting 1: R-CM R-CM 1 + 0.105 = 1.105 1.105 xy 6 = 1.820 428 7 1.820 428 7 - 1 = 0.820 428 7 M-.. Now we may calculate the numerator. Since we know from our pre- vious calculation that the value of (1 + i)" is 1.820 428 7, we may begin with that value and then multiply it by i, or 0.105: 1.820 428 7 x 0.105 = 0.191 145 0. Proceeding, we may divide 0.191 145 0 by 0.820 428 7, which has been stored in the memory, to obtain our capital recovery factor: 0.191 145 0 + R-CM 0.820 428 7 = 0.232 981 9. This is the same factor we computed before using the much simpler calculator without the xy key. Rather more elaborate calculators than those we have been discussing 408 MEASURES OF PROJECT WORTH here also have a role to play in project analysis. Calculators designed for business use are available that calculate present worth or even internal rate of return directly from a series of numbers keyed into the calculator. Hand-held calculators programmable with magnetic cards have many potential applications. In agricultural projects they may be used to calculate farm budgets and-most conveniently-herd projections (Espadas 1977). A herd projection that may take even a skilled livestock specialist eight hours to calculate using a simple calculator can be pre- pared in one or two hours using a card-programmable calculator. The implications for sensitivity analysis are obvious. The use of computers (as opposed to calculators) in agricultural project analysis is still limited, but the use of "minicomputers" is spreading rapidly, and programs for agricultural project analysis are being de- veloped by the Food and Agriculture Organization and the World Bank. One well-known application of large computers is to optimize cropping patterns using linear programming (see Norton and Solis 1982), but this has been limited for the most part to research efforts and has not become common in operational project evaluation. Computer programs are available for herd projections (Powers 1975). The Inter-American De- velopment Bank has published a computer program to appraise farm development projects (Westley 1981). The Food and Agriculture Orga- nization has developed a program for project analysis that is suitable for small computers. A recently developed World Bank program called Com- puterized Project Analysis Support System, for which the acronym COMPAss has been adopted, is available for use by project analysts who have access to larger computers. The program can prepare pattern farm budgets, develop project cost tables, do financial analyses of nonfarm enterprises, and elaborate other tables unique to the individual project analysis. From these components it can then aggregate to the project cash flow, calculate measures of project worth, and perform sensitivity analyses. One very convenient use of large computers is for "table mak- ing." Programs are available that accept information, arrange it, per- form calculations with the data supplied, and then print the result in the form of a table that may be photocopied and included directly in a project report. Information about computer programs for project analy- sis may be obtained by addressing the Director, Information Resource Management Department, World Bank (Washington, D.C. 20433, U.S.A.). Appendixes �. � - ""�"''� - � � ..ww.� * . °� .. . �i „�,_ . -_ � - - � � т•��.��_ ` `9.` н 1iьг.� " � � а _ • �� k - ' � ь�i1. � . _ в� �Wвri _ " � F � л ��i� + � � � . , - у �у � . л 1 .��"` iw. '� � �.. ' � i' � � '�' а r.и а � У г � � '� +�. t а �. � �� _ � . _ � �� ,`� �'' � \ ___,� � Г ` _ � _ � � �� . ` :г~ �� ..-- j 0. - ..S7Zв.S х � - .� у , е �,�. �'� � ` уΡ� i . � �� j� / � ,/ - �1,`4 "л, � .•�г/^ - . в=- , � � _ `_ _. t � � �� ..\�� t � �� , � �� •�. � \ '+ 1� , J .. �� .��'%.. \ ` /�/ �"f�"мЯ w. . ' '\ � \ k�i• .�ивt+хь., У+ rJ��м��. F� ч�ь� �и� � 1� ,`i � . �� _� \ "^^"`А�� . у , -� €_ ,� • - � '�,- � ';� � � ь,� е � � �l.. � � � �.' � ► \' `` - � � ��,� � 3� ��jI � � � �Ъ !ь . ,,,,��1Е�' '`l `' iat�X; S� ,�"' � ` ' '�� д i � � �,, ^ ям �,.., � ,�t ;w4►.�^ t , o- � ;� � -- � � �� : - _ .� �,� �Й. � . � �ч�. � � : � '_..�"�1 . Appendix A Guidelines for Project Preparation Reports THE GENERAL GUIDELINES in this appendix are intended to give an idea about the scope and content of a preparation or appraisal report for an agricultural or rural development project. Most projects in agriculture and rural development are adaptable to a fairly standard form of pre- sentation. The format outlined here can provide the analyst with a starting point. It will give the readers of the report a narrative with supporting tables and annexes that succinctly convey the information necessary for them to form their own conclusions about the worth of the proposed project without confounding them with unnecessary or ex- traneous detail. These guidelines emerge from the combined experience of the Food and Agriculture Organization (FAO), the World Bank, and other interna- tional lending institutions. They are adapted, often verbatim, from mate- rials prepared by the FAO Investment Centre for the use of project analysts in developing countries and its own specialists (FAO 1975 and 1977). In addition, the Investment Centre has prepared a series of specialized guidelines for particular kinds of projects, which are available from the center on request. A comprehensive set of outlines for many different kinds of agricultural projects has also been prepared by the Inter- American Development Bank (1978). Facing page: Picking maize in Guatemala. 411 412 APPENDIXES Clearly, the substance of a project preparation report is more impor- tant than its format. Obviously, too, different elements of a report will need different emphasis depending on the kind of project. The analyst will want to vary the format given here according to the type and complexity of the project he is presenting. On the one hand, these general guidelines touch on many more topics than are needed for any but the most complex project, and the topics mentioned tend to overlap. On the other hand, topics essential to understanding many kinds of agricultural projects have been omitted. This is especially true for projects with significant marketing and processing, rural industry, and rural road components. The analyst will want to leave out topics addressed in these guidelines that are not essential to an understanding of the particular project and to include additional topics that are critical to forming a judgment about the project at hand. He will want to deal with any of the relevant topics in only one place in the report so as to avoid excessive repetition. As a rule of thumb, a project report should aim at a main text of about twenty-five single-spaced typescript pages for a straightforward agri- cultural project and of no more than fifty pages for a complex rural development project. This should be supported by a series of annexes, possibly in a separate volume and reproduced in fewer copies. Work- sheets, detailed assumptions, and the like may be gathered into a project file and kept at some central location where anyone interested may find them. As far as possible, the main text should present the project in a form that a nonspecialist can understand; specialized back-up informa- tion-including maps, charts, and detailed tables-should be reserved for the annexes or the project file. The principal elements of a project preparation or appraisal report are outlined in the following pages in the order in which they normally appear. 1. Summary and Conclusions The main purpose of this part, generally only a page or two in length, is to give the reader the essential elements of the project very briefly. It should cover the rationale of the project and its priority, purpose, loca- tion and size, beneficiaries, main components, investment period, costs, organization, financial and economic effects, and main issues. 2. Introduction This part, which is a nontechnical one, usually mentions the arrange- ments through which the project report was prepared. It can indicate the origin of the project concept in the national development plan, in a sector survey, or by a project identification mission. It might mention the government agencies and other organizations involved in the prepara- PROJECT PREPARATION REPORTS 413 tion and any external assistance received. It can acknowledge the team that prepared the project and the report and can mention the period in which they worked. None of the information needs to be given in much detail. 3. Background To the greatest extent possible, background material should be annexed to the report. A well-thought-out and properly constructed background discussion, however, can do much toward establishing the framework of the project and making it intelligible in a broader eco- nomic and social perspective. The analyst needs to be very discriminat- ing when choosing material for this part. The only general guidance is that there should be a clear relation between this material and the contents of other sections of the report. The tendency to ramble is usually more pronounced here than in other parts of the report. 3.1 Current economic situation This discussion could mention per capita income, dependence on par- ticular imports and exports, balance of payments considerations, and the like. It should cover only those features of recent economic developments that have a bearing on the project and on studies of the possible alterna- tives to the project. 3.2 The agricultural sector This section might describe the main characteristics of the agricul- tural sector of the country, including constraints to overall development and a description of relevant subsectors. 3.3 Development and social objectives This section might outline development and social objectives as ex- pressed in national plans and official policy statements. It could note the main elements of the national strategy for agricultural development and mention significant government policies, including price and interest rate subsidies, supply of inputs, targets for rural income, regional bal- ance, and the like. 3.4 Income distribution and poverty If a project is designed to benefit a particular group of the rural poor, a discussion of income distribution and poverty would be appropriate in the background section. The information should establish a framework for the eventual justification for selecting a particular region or line of action for priority attention under the project. It should cover informa- 414 APPLNDIXES tion about income distribution on a national basis and give a regional or social dimension to the data. 3.5 Institutions This paragraph might describe the institutions concerned with de- velopment and financing in the sectors covered by the project. These might include the ministry of agriculture, the agricultural development bank, the livestock development authority, and the like. 4. Project Rationale This part should make a persuasive argument for selecting this project for priority attention. Against the background of the previous part, it should fully discuss the development opportunities and constraints within the relevant sectors. It should also explain why a particular development strategy has been decided for this project and establish the technical, social, and economic reasons for the selection of this particular project in preference to possible alternatives. This may also be the best point at which to indicate the scale of the proposed project and to explain why a certain size has been chosen. Finally, there should be a discussion of the project risks and the steps that have been taken in project formula- tion and that should be taken in project implementation to minimize them. 5. Project Area The objective of this part, and the details in the supporting annexes and maps, is to present a description of the existing status of the area where the project will be located and to give the basis from which the project starts. These descriptive data should be presented in the relevant physical, agricultural, social, economic, institutional, and legal terms. The part should evaluate, in a narrower sense than the discussion of the agricultural development strategy and the project concept, the develop- ment opportunities and potentials as well as the limitations the area presents, focusing throughout on the project description that follows. 5.1 Physical features This section will deal with the main geographical and topographical features of the area and relate the area to important features of the country as a whole. The principal objective is to show that the climate and soils are suitable for the crop and livestock production proposed. 5.1.1 GEOGRAPHICAL LOCATION. The general location of the project area within the country is identified, and then the area is defined more pre- PROJECI PREPARATION REPORTS 415 cisely in relation to administrative boundaries and other criteria. The project area might, for example, be a province, a district, a watershed, the command area of a dam, or a combination of these. A tree-crop rehabilitation project might be concerned with particular estates or plantations. Some projects will concern only farmers who produce par- ticular crops but may be spread over a large area. 5.1.2 CLIMATE. This section should cover rainfall, including monthly and annual totals, intensity and variability, temperatures, humidity, evapotranspiration, and the like. Available records and more technical information may be summarized in the annexes. For a dryland farming project, the objective is to show that the amount and timing of rainfall is appropriate for the cropping pattern proposed. For irrigation projects, the rainfall record supports conclusions about when irrigation water is needed and in what volume. 5.1.3 GEOLOGY, SOILS, AND TOPOGRAPHY. Information in this section should support conclusions about the land in the project-its agricul- tural potential, its suitability for irrigation, its needs for drainage, and the like. Judgment will be required about the scale of the maps of soil and land classification to be included in the report. In project preparation, detailed maps will be needed; in the annexes to the preparation or appraisal report, simply a reference to the detailed maps (kept on file) and a summary map of quite small scale may suffice. 5.1.4 WATER RESOURCES. Surface and underground water resources should be described to the extent they are relevant to project decisions. Usually this is done from the viewpoint of irrigation and drainage, but it may also have a bearing on provision of water for domestic use. 5.2 Economic base This section should cover the main economic features of the project region. It may tend to overlap with some of the social aspects in the following section (5.3). Duplication, of course, should be avoided. 5.2.1 AGRICULTURAL AND LIVESTOCK RESOURCEs. The agricultural and livestock resources of the region should be described briefly and the major features quantified. The importance of these sectors in the econ- omy of the region, the proportion of people employed in these activities, the area and output of major products, and an approximate estimate of the value of these products may be given. Recent trends should be noted, and the relative importance of the sector to be assisted under the project should be emphasized. 5.2.2 LAND USE, FARMING SYSTEMS, AND CROPPING PATTERNS. The present land use should be described. This will include information about land tenure, farm size, cropping patterns, crop varieties and livestock breeds, crop yields and livestock production, and inputs. Much of this material 416 APPENDIXES can be presented in tabular form in the annexes and only a commentary given in the main text. A short description of agricultural practices and level of technology for each main farming system may be in order. Results achieved on experimental stations in the area may be mentioned, and the performance of individual farmers who have tested the proposed system can be noted to indicate potential production. Constraints should be clearly described, including such factors as social customs, land ten- ure, technical shortages, and lack of extension that might prevent farm- ers from reaching acceptable production levels. 5.2.3 INPUT SUPPLY AND PRODUCT MARKETING. A concise description should be given of existing channels for the supply of inputs and of the facilities for marketing farm production. The effects of such government policies as price supports, input subsidies, taxes on products, and the like may be described and evaluated. 5.2.4 OTHER ECONOMIC ACTIVITIES. There may be other economic activ- ities in the area that are important to an understanding of the project. These may include forestry, fishing, rural handicrafts, and processing industries. If data are available, the number of families engaged in secondary activities may be indicated, with at least an approximate indication of their importance to the rural economy. 5.3 Social aspects Social features of the project area should be described under appropri- ate subheadings. Many topics will overlap with other sections, and a decision will have to be made about where in the report to treat certain topics to avoid duplication. 5.3.1 LAND TENURE AND SIZE OF HOLDINGS. When land tenure is particu- larly important in a project or where extensive changes are contem- plated, it may be more relevant to include land tenure with the discus- sion of the social aspects than with the discussion of land use (5.2.2). Land tenure should be discussed with reference to the proportion of owner- cultivators, tenant cultivators, and landless labor. If possible, the size of holding may be related to the kind of tenure. The descriptions should refer to any changes in land tenure caused by agrarian reform or settle- ment. 5.3.2 POPULATION AND MIGRATION. Data may be given that illustrate such aspects of population as density per square kilometer, pressure of population on the cultivated area, dependency ratios, and the literacy rate. It may be relevant to define the rural population, since towns in the project area may be more like large rural villages than small urban centers. When migration is important, annual or seasonal flows may be described and, if possible, quantified. If rural-urban migration is an important issue, its significance and extent may be discussed. A discus- sion of labor supply may be important if proposed cropping patterns depend on hired labor. A discussion of unemployment and underemploy- PROJECT PREPARATION REPORTS 417 ment in the project area or nearby and its seasonality may be relevant. Income levels will have been referred to earlier, but the discussion of the social aspects may include more detailed information about the project area and about other indicators of the quality of rural living such as housing, health, and nutrition. A population projection for the project area over the project life may be included, as well as a discussion of the implications this may have for the project. 5.3.3 SOCIAL SERVICES. When it is important to an understanding of the project and the reasons for its selection, the social services available in the area may be discussed. These services may include primary and secondary schools, dispensaries, and other facilities. Disease problems in the area and possibilities of their control may be discussed. Mention should be made about which social services function well and which may need improvement. 5.4 Infrastructure The treatment given to infrastructure will depend on the extent to which the project itself will have infrastructure-related components. Some projects are concerned exclusively with providing rural infrastruc- ture, in which case, of course, the weight given to this section would be substantial. It may be relevant to quantify the total length of project roads, annual tonnage moved, recent growth in traffic, and the like. The relevance of infrastructure to marketing of project output and to the supply of inputs should be mentioned. Water and electricity services within the region may be briefly described. The number of families served by various infrastructure facilities may be quantified. Ongoing improvement programs may be briefly evaluated. 5.5 Institutions This section, which supplements the discussion of the national situa- tion in the background part of the report (3) should describe the local activities of national agencies or of any special institutions, such as local development authorities, operating in the project region. The main pur- pose of the section is to provide a basis for understanding the proposals about organization and management of the project that are outlined later. The reader of the report will want to know which institutional arrangements are working satisfactorily and which will need sup- plementary attention under the project. 6. The Project Previous parts having set the framework of constraints and opportuni- ties for the project, this part and its supporting annexes should define and describe in detail the objectives of the project and its works and activi- ties-their phasing, their costs, and how they will be financed and pro- 418 APPENDIXES cured. As always, the emphasis on particular elements outlined below will vary with the nature of the project, and topics not mentioned may be essential to an understanding of the project. The analyst should adapt this part especially to fit the project. 6.1 Project description This section should give a brief overview of the objectives, location, size, components, and other important features of the project. It serves simply to suggest to the reader of the report what to expect in the more detailed sections that follow. Three or four paragraphs should suffice. 6.2 Detailed features The objective of this section is to describe the proposed project works and other components that make up the project item by item and cate- gory by category. It should concentrate on the technical aspects and describe what is to be done in sufficient detail to establish the nature, scope, and cost of the various measures proposed. It should be backed, where necessary, by supporting annexes. Consideration of the costs of implementing the measures is taken up in the section about project costs (6.4), and the manner of implementing them is outlined in the part that discusses organization and management (7), but cross references here may be helpful. 6.2.1 WORKS AND GENERAL FACILITIES. This section includes discussion of irrigation facilities, general infrastructure for settlement projects, access roads, extension facilities, and social infrastructure such as vil- lage water supplies, health clinics, schools, and rural electrification. If a development authority is responsible for undertaking construction work, a list of equipment needed for the project may be included here. Similar provision may be made for equipment for operation and mainte- nance of project works. 6.2.2 ON-FARM INVESTMENT. This section will discuss items such as fencing, farm irrigation and drainage systems, land clearing and level- ing, pasture development, and the like. The distinguishing feature of such works is that they are normally carried out by farmers or at the expense of farmers on their own farms, with the project making available credit and perhaps arrangements for the work to be carried out. They are best illustrated by farm budgets that represent the kinds of cropping patterns and livestock enterprises to be undertaken. Farm budgets are also important to the discussion of farm income (8.3) and elsewhere in the project report. As suggested in the discussion of farm income in section 8.3, a centralized analysis is desirable; this probably should be given in an annex. 6.2.3 FARM BUILDINGS AND EQUIPMENT. This section discusses irrigation pumps, sprayers, on-farm storage facilities, tractors, livestock sheds, and PROJECT PREPARATION REPORTS 419 a wide range of similar items that in general are made available to farmers through credit arrangements. 6.2.4 CREDIT PROGRAM. If credit is to be provided as part of an overall project, it may conveniently be discussed at this point. This discussion may include the required total amount of credit derived from aggregat- ing farm budgets and the applicable credit terms. If the project is pre- dominantly one to provide credit, only a discussion of the totals involved may be needed here. Detailed discussion of the credit program may be reserved for the section on credit administration (7.1) and the specialized annexes. 6.2.5 PROCESSING AND PRODUCT-MARKETING FACILITIES. Processing and marketing facilities needed under the project may be described in this section. If processing facilities are a large component of the project, this section may be limited to a general description. The detailed discussion can be concentrated, as appropriate, in the sections devoted to marketing structure (7.2), to availability of markets (8.2), and to processing indus- tries and marketing agencies (8.4). As is the case with farm budgets and discussion of a credit agency, a separate annex with detailed accounts for processing and marketing enterprises and with a full discussion of orga- nizational and other problems may be desirable. 6.2.6 SUPPORTING SERVICES. Special supporting services included in the project may be described here. Of particular importance is provision for extension. The number, grade, and availability of additional exten- sion officers may be mentioned, as may their requirements for transport, office equipment, and housing. If the project includes components to train staff or farmers, the relationship of these to national facilities may be described and any facilities such as classrooms and dormitories out- lined. 6.2.7 SOCIAL SERVICES. Any social services envisioned under the proj- ect should be included in the description of the detailed features. Health services and disease control may be important project activities. The particular actions anticipated should be described and quantities given if new staff or facilities are needed. If education is a project component, the new schools should be described and the number of pupils foreseen given, along with the number of teachers needed. A discussion of domes- tic water facilities and the number of households involved may be in order. 6.3 Project phasing and disbursement period This section should describe in detail the phasing of the proposed project actions, including works and general facilities, farm develop- ment, processing and marketing facilities, supporting facilities, and so- cial services. From this section are derived the justification for the phas- ing of expenditure and the disbursement pattern of any loan envisioned 420 APPENDIXES for the project. In most cases the disbursement and development periods of agricultural projects extend over three to five years, and this section should address this time horizon. Some projects, such as those involving tree crops, entail a longer phasing and disbursement period. This section might be supported by an annex containing a detailed graphic presenta- tion such as a "critical path diagram" to indicate the sequence of project activities and which activities cannot be delayed without delaying the whole project. [For a discussion of critical path diagramming, see Mul- vaney (1969).] 6.4 Cost estimates The importance of accurate cost estimates cannot be overemphasized. They are a crucial element in determining the financial and economic viability of the project and also for planning its funding. The main text should give aggregate cost in a summary table; the complete cost break- down can be given in annexes. There are many ways to group costs, but a common one is to distinguish between capital and recurrent costs. Costs should be broken down to show local and foreign exchange components. The foreign exchange component includes expenditure for both directly and indirectly imported goods and services. Costs in this section would be presented in constant financial, not economic, terms, and they would be shown at market prices. Duties and other taxes would also be shown, but these should be separately indicated, at least in the annexes. Current costs would be given as part of the financing plan (6.5.4). 6.4.1 CAPITAL COST. The headings under which capital cost is summa- rized and discussed in the main report preferably should correspond to the approach adopted for the physical description of the items. The estimate for civil works should be based on unit rates and quantities. If equipment for construction or operation and maintenance will be pro- cured under the project, the cost of these should be shown separately. The cost of on-farm development works is determined by aggregation from the pattern farm budgets. Often only those items to be financed by credit, or the amount of the credit needed, will appear in this section. To aggregate from the farm budgets to the economic cost of the project, however, the full incremental cost incurred by the farmers will be needed. If land is acquired for project purposes and a cash outlay is required, this outlay should be included in the items of capital cost. But if the government provides the land free of cost, land will not be included as a project cost item; the opportunity cost of the land, however, will be allowed for in the economic analysis. 6.4.2 RECURRENT COSTs. Either in this section or in the section devoted to financing (6.5), provision will have to be made for the recurrent cost needed for project operation. Recurrent cost usually refers only to the budget for the proposed executing agency. PROJECT PREPARATION REPORTS 421 6.4.3 CONTINGENCIES. It is common for the cost estimates to include a physical contingency allowance, usually on the order of 10 or 15 percent. Price contingency allowances are covered in the section on financing (6.5) or in the section on the budget of the government operating agency or project authority (8.5). 6.5 Financing It is important to prepare a financing plan for the project so that the government may be fully aware of the immediate and future budgetary implications of the project. The plan may be summarized in tabular form in the main text of the report, and supporting detail may be included in the annexes or in separate documents. Completion of the full financing plan may need to await completion of negotiations with outside financ- ing agencies, but it may be possible to include in the preparation report totals of at least the most important items, with the notation that some sources of financing remain to be determined. Some of the elements of the financing plan will grow directly out of the project preparation. For example, when the analyst draws up the credit program, a decision will have to be reached about the down payments to be made by farmers and the rate at which they will be required to repay their loans. Similarly, estimating the foreign exchange component of the project tends to put a ceiling on the proportion of total cost to be met by an outside financing agency. 6.5.1 INVESTMENT COST. The amounts needed by the project each year during the investment phase (or disbursement phase, if outside financing is involved) should be tabulated by major category and broken down into domestic currency and foreign exchange. When known, the proportion of total cost to be borne from domestic sources and that to be financed from outside may be indicated. 6.5.2 TAX REVENUE. If the project will generate significant new tax revenue, as might be the case if the project will increase production of a crop on which an export tax is levied, the amount and timing of the new revenue should be detailed. 6.5.3 RECURRENT COST. A projection should be made of the recurrent cost necessary to operate the project once the investment phase and any anticipated receipt of foreign financing ends. This will indicate the con- tinuing burden on the treasury of maintaining the project administra- tion. This projection will need to be related to the section on the budget needs of the project executing agency (8.5) and to the policies outlined in the section on cost recovery (8.6). The net burden allowing for any increased tax revenues may be noted. 422 APPENDIXLS 6.5.4 CURRENT COST. Since the project cost normally is stated in con- stant terms, the financing plan should address itself to a tabulation of the investment and recurrent cost in current terms once the project is under- taken. This will become the basis for the budget allocation as the project proceeds. Since this may involve making a politically sensitive judgment about future rates of inflation, this part of the financing plan may appro- priately be dealt with in a separate memorandum addressed to the ministry of finance. 6.6 Procurement Special requirements for procurement may be mentioned in this sec- tion. If it is contemplated that financing will be sought from an interna- tional lending agency, speci4l procurement regulations may have to be noted. 6.7 Environmental impact Nations are increasingly concerned about the environmental impact of proposed projects, and decisionmakers will want assurances that proper attention has been paid to environmental considerations and that any adverse ecologic effects have been minimized. If a significant environ- mental impact is likely, full treatment in an annex may be called for; otherwise, a short explanatory paragraph will suffice. 7. Organization and Management In general, the part on organization and management is intended to show which entity or entities will be responsible for the various aspects of project execution and operation and how these entities will carry out their responsibilities. The discussion should demonstrate that the ex- ecuting agencies have adeqqate powers, staffing, equipment, and finance. It should show that there are adequate arrangements for coor- dination between and within the administrative groups responsible for the various project activities. If there are deficiencies, the changes and improvements required should be clearly stated. For each administrative group, this part of the report should give details of legal status, functions and powers, internal organization, staffing, and the like. If the administrative agency is not a government department, it may be desirable to give details about the legal charter and governing board, how the board is appointed, and any special provi- sions concerning its budget. When there is more than one agency concerned with a project, the arrangements for coordination, joint representation on boards, joint committees, and joint use of field facilities may be described. PROJECT PREPARATION REPORTS 423 This part should address the ability of the senior management of an implementing agency to decide policies, approve important expendi- tures, and appoint the project management responsible for day-to-day operations. It should discuss the number and caliber of the project staff and whether their assignment will permit them to devote enough time to the operation of the project. The qualification and experience of the key management staff may be noted either in an annex or in a separate memorandum. The needs of the project for professional technical staff and the expected availability of such staff should be mentioned. Arrange- ments for recruitment and staff training should be described. Any neces- sary provision for assistance from expatriates should be noted and de- tails about the qualifications of expatriates given. Projects with special emphases will require a discussion of the orga- nization and management requirements imposed by the nature of the particular projects. Several of these special requirements are noted in the following sections. In some instances, a detailed discussion in the annexes will be appropriate. 7.1 Credit administration If credit is important in the project or if the project is predominantly an agricultural credit project, particular attention must be paid to the administrative capability and financial status of the credit agency. In the main text only a summary statement may be necessary, but in the annexes it may be desirable to go into considerable detail. Such details should include projected accounts for the credit agency and a thorough analysis of the position of the agency concerning arrears in repayment of loans and interest delinquencies. Other points to be considered are the legal charter, capitalization, powers and functions, direction, manage- ment, delegation of authority, internal organization, staffing, accoun- tancy and control, auditing, operating policies, terms and conditions of loans, collateral requirements and their appropriateness for the group the project is intended to benefit, procedures for loan appraisal and disbursement, and the capability of the agency to operate in a timely and effective manner in the project area. Arrangements for administrative improvements and staff training should be mentioned. 7.2 Marketing structure In this section the organizational arrangements, both public and pri- vate, for marketing farm production should be described and assessed. Particular attention should be paid to any rigidities or insufficiencies, and to proposals for correcting the situation if these inadequacies are relevant to the project. A separate annex discussing marketing institu- tions and proposals to improve them may be desirable if marketing is an important component of the project. This section should be related to that dealing with the financial effects of the project on processing indus- tries and marketing agencies (8.4). 424 APPENDIXES 7.3 Supply of inputs This section should discuss the responsibility and arrangements for the provision of supplies for farm production and should mention pro- posals, where necessary, for improved supply of such inputs. If labor availability was not discussed in the section on population and migra- tion (5.3.2), it may be appropriate to address the question here. 7.4 Land reform If the project will involve any change in land tenure or distribution, the agency responsible for such matters should be described and assessed. There should be a discussion of relevant land laws, cadastral aspects, conditions of tenure, and-in settlement projects-farm size and selec- tion of settlers. Particular attention should be paid to the timing and implementation of land reform measures. 7.5 Research If new research or additional field trials are to be needed, the arrange- ments and staffing should be discussed. If expatriate specialists will be needed, their qualifications and responsibilities should be outlined. Plans for staff training should be mentioned. 7.6 Extension The arrangements to bring new information about production to farm- ers in the project area should be discussed. Special equipment and facilities should be outlined and justified unless they have been dealt with in the section on supporting services (6.2.6). Staff training, espe- cially for field agents in the project area, should be outlined. 7.7 Cooperatives If it is intended that cooperatives will be used in the project, the relevant legislation, organization, structure, and operating record of the cooperatives and the agencies responsible for encouraging or adminis- tering them should be discussed. Proposed measures for development of cooperatives in the project area, including staff training, should be de- scribed. 7.8 Farmer organization and participation The responsibility for any other measures to encourage farmers' par- ticipation in the project, to establish farmers' associations, and to ensure good relations between farmers and the project administration should be discussed. PROJECT PREPARATION REPORTS 425 8. Production, Markets, and Financial Results By the time the reader reaches this point in the project report, much ground will have been covered: the national setting for the project and the reasons for its selection; the project itself, including its technical aspects and costs; and the proposed manner of implementation. From here onwards, emphasis is on the financial and economic feasibility of the project. The report should show that the results of project actions will be sufficiently attractive financially to encourage enough farmers to participate. For processing industries or marketing agencies, the report should demonstrate that it will be financially viable for such firms to participate in the project and that their financial return will be suffi- ciently attractive. 8.1 Production The primary benefit of an agricultural or rural development project is usually incremental output from project farms. This is generally the basis on which the project is formulated in the first place, and the physical results to be expected are illustrated in the farm models. Project actions may permit introduction of completely new and more valuable crops but more often will be directed toward increasing yields of existing crops or permitting a more intensive form of livestock production. In any case, the assumptions about yield or livestock production, both with and without the project, should be fully supported in the annex materials. In this section, attention should be directed toward the aggregate increase in production that is expected. Account should be taken of such factors as the number and phasing of the farms included in the project and the build-up of average yields as farmers adopt the improved tech- nology or as new plantings of tree crops approach maturity. A table showing aggregate build-up during the development period of the proj- ect may be included in the annex. 8.2 Availability of markets This section should demonstrate that satisfactory markets exist for the product of the project. The market must be of sufficient size to absorb the production proposed for the project. If the scale of the project is large enough to exert an appreciable influence on the market, this effect will probably require fairly detailed treatment in an annex, but only the salient points need be mentioned in the main text. If an export commod- ity is involved, attention should be paid to such special situations as preferential treatment, long-term contracts, or quality preferences. Domestic pricing policies should be fully covered, either in the main text or in a special annex, if they are a matter of extensive debate or if significant policy changes will be required for the project. This section 426 APPENDIXES will also mention prices for internationally traded commodities and summarize the results of the import and export parity price calculations that are given in more detail in annex text and tables. 8.3 Farm income The effects of the project on farm income are demonstrated through presentation of farm budgets such as those outlined in chapter 4. Because farm budgets are fundamental to any agricultural or rural development project analysis and will also have been referred to in connection with on-farm investment (6.2.2) and the topics of other sections, it is impor- tant to present a fully developed analysis in the project report. This probably can be most conveniently done in one annex, which should include farm budgets that indicate the inflow and outflow for each major farm model anticipated in the project, outline financing needs, and project the incremental net benefit the farm family may expect. 8.4 Processing industries and marketing agencies A discussion of the financial effects of the project on processing indus- tries and marketing agencies may be in order if the project contains such components. A summary in the main text may suffice, but detailed projections of balance sheets, income statements, sources-and-uses-of- funds statements, and the incremental cash flow should be included in appropriate annex material along the lines discussed in chapter 5. 8.5 Government agencies or project authorities In some project reports, especially if the project is to be administered by a largely self-supporting project authority, an analysis of finances from the standpoint of the administering agency may be in order. This section could include expected inflows and outflows of the project au- thority and the government budget amounts required to support the project. It should be related to the cost recovery section below (8.6). Annex materials along the lines suggested in chapter 6 may be included. Care should be taken to avoid duplication with the section on financing (6.5). In some reports, it may be desirable to centralize the financing plan here and simply to cross-reference it in the section on financing. In any case, if much detail is to be included it may conveniently be gathered into an annex to which both sections can refer. 8.6 Cost recovery This may be an appropriate point in the report to mention any arrange- ments made to recover part of the cost of the project from beneficiaries. (Usually this section will not address recovery of loans; this matter should be discussed in the sections bearing on credit.) Appropriate cross- references may be made to the section on financing (6.5). In most cases, PROJECT PREPARATION REPORTS 427 farmers will be called on to share the cost of the initial investment in on-farm works under the financing plan of the project. The question of cost recovery frequently arises in irrigation projects, in which there may be a problem about the extent to which farmers should bear the cost of operation and maintenance. This may involve questions of government policy about income distribution, or even foodgrain prices, and of finan- cial arrangements in other irrigation projects. 9. Benefits and Justification This is a crucial part of the project report in which all data discussed in previous parts are brought together and an assessment made-all things considered-about whether to proceed with the project. 9.1 Social benefit A project usually will have benefits beyond those that are simply financial and economic. A general section may be devoted to the effects of the project on food production, import substitution, foreign exchange earnings, and the like. If the project is of interest mainly because of its social benefit, such as its beneficial effect on the incomes of the poorest farmers, this section takes on added importance, and separate sections devoted to one or another significant social aspect may be in order, as noted below. Because these topics will have been discussed in earlier sections, care should be taken to minimize duplication, and only a brief summary may be needed. 9.1.1 INCOME DISTRIBUTION. The extent to which the income of the poorest sector of the rural population is improved as a result of the project may be shown. Reference must be made to the relative improve- ment in comparison with other groups in the country. 9.1.2 EMPLOYMENT. The extent to which the project reduces underem- ployment and unemployment may be assessed. This may be quantified in terms of work years created by the project, with distinction made be- tween permanent employment and employment during the investment or construction phase. The number of jobs created might be compared with the expected increase in the labor force of the project area. 9.1.3 ACCESS TO LAND. If the project includes a land settlement or land reform element, the distribution of land rights with and without the project should be demonstrated. 9.1.4 INTERNAL MIGRATION. In countries where rural-urban migration is a serious problem, it may be useful to note the possible effect of the project on rural-urban migration. Quantification will probably prove difficult. 428 APPENDIXES 9.1.5 NUTRITION AND HEALTH. If the project is located in an area where serious nutrition or health problems exist, or if the project is directed toward groups with nutrition and health deficiencies, the expected effects of the project on these problems might be mentioned. In some cases, the effect on nutrition may be quantified in the daily intake of calories or protein that is expected as a result of the project. 9.1.6 OTHER INDICATORS OF THE QUALITY OF LIFE. Some projects may have a significant effect on the quality of rural life through improvements in access to domestic water supplies, electricity, schools, and the like. These may be mentioned and the quantities of the new amenities noted. 9.2 Economic benefit Finally, the economic desirability of the project should be assessed. Economic costs and benefits are valued along the lines discussed in chapter 7, aggregated as discussed in chapter 8, and evaluated using one or more of the measures of project worth as discussed in chapter 9. An integral part of this section will be to demonstrate through sensitivity analysis, as discussed in chapter 10, the effects of different assumptions about efficiency and prices on the project's wealth-generating potential. 10. Outstanding Issues Almost every project will have outstanding issues that must be re- solved after the preparation report is presented. These considerations may relate to project rationale, policy issues affecting the project, man- agement and other staffing issues, and financing arrangements. The most important of these should be set forth explicitly so that they are drawn forcefully to the attention of readers who must take the necessary ac- tions. 11. Annexes The annexes to the preparation report contain the detailed support for the project. The main text is written with the general reader in mind, but the annexes will generally be examined in detail primarily by specialists and should be written with the specialist in mind. A large proportion of the annex materials probably will be in the form of tables, maps, draw- ings, charts, diagrams, and photographs. The annexes will vary widely according to the kind and complexity of the project. They usually are presented in the order in which they are referred to in the main text. Often they are published in a separate volume and reproduced in only the number of copies needed to supply the various specialists and agencies directly concerned with project decisions. Among other topics, annexes may include an amplification of the part on the background of the project PROJECT PREPARATION REPORTS 429 (3); surveys, investigation, laboratory results, and data analyses and interpretations to support the part on the project area (5); studies, de- signs, estimates, and schedules to support the part on the project (6); detailed proposals to support the part on organization and management (7); farm budgets, projected enterprise accounts, market assessments, and other information to support the part on production, markets, and financial results (8); and analytical material, including shadow prices and assumptions about the foreign exchange premium, to support the part on benefits and justification (9). у�..ь�.,, .,r: � , '�w"iYi►. - - к - - _ - 'ГуΡ��Ь. �-� � �,�- �У'`а°'л �� i� � У � у ,:У{` ... _� .. ...,лХ`" ., � .г .. ' ' �� . �„ ..� ,у �, � г'� ' �;ж? ;,ц.;�!� _ - .� �: • '�� '� :� - ;� .г r _ ,,. ,,�Л ; �rt� � лr . ; n .r�•� ��. ^Е � т '' {� , ' ,уу' ' у/ - : _ r'•� .�.'�" `� . �` '�' � i - � ,�� _ н � • 1 • - � � ь� '�'� ц -(� �' �� t � у � . �г в • � . � "'3 ;� <-�� w�s.,• ' � ы� , {� . ;� " ._ , , v �� , � '..: _ � � . � - ��} L� ь ,� � ` '�j г � , . „�..�.�`�. ' : i •`.:J' � .' ' '}�' У�' �• �+fi , д � � • � � �3 � �.�� sr.� .- ...,..��... ...л.��,.� ' .FУт� �р,��4�1�, _'�{ _,� _У r hi+'i�M1�.��- �•�� э р� �� ± ,� Т 7 ` ��. !i% � �� ..k _ IIr . � � К. ` �.� � _ - _ . .м . � s ;у �, �-Si ' 1 ' ,- ' � � �-г ° 2. ь г_ 1 _ _ I �.,: g < . в � If :� м t - � \а '�� " � ° ,,,у - ' " � У У ` ` � -ев'^- ..""л- Jл11.. � � - �, .� , ..� _�,,^._� л ' � .`��-_� �.,�� „�,,,... ' "� '* '�'� 'i�у•.!',� *� �+. � � , .лз.ы '* � йЭi - ��.: , -�:��:� . �� д � �. - .. � �д д� ,. � . � �. � й4, .1I�` .й �._ , �. �. ,�а- � .�',� „a- .r, ., � .� о� ' ��в .. ..�4... - .. Appendix B Three-decimal Discounting Tables To CALCULATE most discounted measures of project worth the three- decimal discounting tables reproduced (from Gittinger 1973) at the end of this appendix are sufficient. In general, they will permit estimations to three significant digits for net present worth, to the nearest whole per- centage point for internal rate of return, and to a hundredth of a ratio point for benefit-cost and net benefit-investment ratios-as much preci- sion as the underlying data will justify in agricultural projects (see the section on "How Far to Carry Out Computations of Discounted Mea- sures" in chapter 9). There are instances in which the intervals between percentage points in these tables will not permit computation of the internal rate of return to the nearest percentage point (see the section on "Computing the Internal Rate of Return" in chapter 9). There are also cases in which the opportunity cost of capital to be used for computing net present worth, the benefit-cost ratio, or the net benefit-investment ratio is not given in these tables. In these instances resort will have to be made to more detailed tables, or the factors will have to be calculated directly. A number of suitable, more detailed discounting tables are available. [Gittinger (1973) contains such a set.] The discount factor, the present worth of an annuity factor, and the capital recovery factor can be calcu- Facing page: Harvesting dates in Tunisia. 431 432 APPENDIXES lated on any inexpensive calculator with memory and repeat features, although the computation can become a bit repetitive. The method is discussed in the last section of chapter 10. When a somewhat more complex calculator with capability to com- pute powers is available, the standard formulas below may be used to obtain directly the factors most commonly used in project analysis. Each formula assumes an interest rate of i per period and a term of n periods. P is the present worth, or the amount at the present time, to. F is the future worth, or the amount in the future at the end of the nth period. A is the annuity, or the level payment, to be made at the end of each of n periods. Compounding Factor for 1 The factor is: (1 + i)". It is used to calculate the future worth (F) of a present amount (P) at the end of the nth period at the interest rate of i. The formula is: F = P(l + i)". Compounding Factor for 1 per annum The factor is: (1 + i)" - It is used to calculate the future accumulated value (F) at the end of the nth period at the interest rate of i, if a sequence of equal payments (the amount of each payment being A) will be made at the end of each of the n periods. The formula is: F=A (1+i)"-1 Sinking Fund Factor The factor is: i (1 + i)" - 1 It is used to calculate the amount of each equal payment (A) to be made at the end of each of n periods to accumulate to a given future worth (F) at the end of the nth period at the interest rate of i. The formula is: THREE-DECIMAL DISCOUNTING TABLES 433 A=F . (1 + i)" - I Note that the sinking fund factor is the reciprocal of the compounding factor for 1 per year. Discount Factor The factor is: (1 + i)" It is used to calculate the present worth (P) of a future value (F) at the end of the nth period at the interest rate of i. The formula is: P=F 1 (1 + i)" Present Worth of an Annuity Factor The factor is: (1 + i)" - i(1 + i)" It is used to calculate the present worth (P) of a sequence of level pay- ments (the amount of each payment being A) to be made at the end of each of n periods at the interest rate of i. The formula is: P=A (l+i)"-1 i(1 + i)" Capital Recovery Factor Tie factor is: i(1 + i)n (1 + i)" - 1 It is used to calculate the amount of each level payment (A) to be made at the end of each of n periods to recover the present amount (P) at the end of the nth period at the interest rate of i. The formula is: A = P i(1 + i)" (1 + i)" - 1 Note that the capital recovery factor is the reciprocal of the present worth of an annuity factor. COMPOUNDING AND DISCOUNTING TABLES 6. Three-decimal Table for Discount Factor, Various Rates DISCOUNT FACTOR-How much 1 at a future date is worth today. Year 1% 3% 5% 6% 8% 10% 12% 14% 15% 16% 18% 20% 22% 24% 25% 26% 28% 30% 35% 40% 45% 50% Year 1 990 971 952 943 926 909 893 877 870 862 847 833 820 806 Boo 794 781 769 741 714 690 667 1 2 980 943 907 890 857 826 797 769 756 743 718 694 672 650 640 630 610 592 549 510 476 444 2 3 971 915 864 840 794 751 712 675 658 641 609 579 551 524 512 500 477 455 406 364 328 296 3 4 961 888 823 792 735 683 636 592 572 552 516 482 451 423 410 397 373 350 301 260 226 198 4 5 951 863 784 747 681 621 567 519 497 476 437 402 370 341 328 315 291 269 223 186 156 132 5 6 942 837 746 705 630 564 507 456 432 410 370 335 303 275 262 250 227 207 165 133 108 088 6 7 933 813 711 665 583 513 452 400 376 354 314 279 249 222 210 198 178 159 122 095 074 059 7 8 923 789 677 627 540 467 404 351 327 305 266 233 204 179 168 157 139 123 091 068 051 039 8 9 914 766 645 592 500 424 361 308 284 263 225 194 167 144 134 125 108 094 067 048 035 026 9 10 905 744 614 558 463 386 322 270 247 227 191 162 137 116 107 099 085 073 050 035 024 017 10 11 896 722 585 527 429 350 287 237 215 195 162 135 112 094 086 079 066 056 037 025 017 012 11 12 887 701 557 497 397 319 257 208 187 168 137 112 092 076 069 062 052 043 027 018 012 008 12 13 879 681 530 469 368 290 229 182 163 145 116 093 075 061 055 050 040 033 020 013 008 005 13 A 14 870 661 505 442 340 263 205 160 141 125 099 078 062 049 044 039 032 025 015 009 006 003 14 15 861 642 481 417 315 239 183 140 123 108 084 065 051 040 035 031 025 020 011 006 004 002 15 16 853 623 458 394 292 218 163 123 107 093 071 054 042 032 028 025 019 015 008 005 003 002 16 17 844 605 436 371 270 198 146 108 093 080 060 045 034 026 023 020 015 012 006 003 002 001 17 18 836 587 416 350 250 180 130 095 081 069 051 038 028 021 018 016 012 009 005 002 001 001 18 19 828 570 396 331 232 164 116 083 070 060 043 031 023 017 014 012 009 007 003 002 001 000 19 20 820 554 377 312 215 149 104 073 061 051 037 026 019 014 012 010 007 005 002 001 001 000 20 21 811 538 359 294 199 135 093 064 053 044 031 022 015 011 009 008 006 004 002 001 000 000 21 22 803 522 342 278 184 123 083 056 046 038 026 018 013 009 007 006 004 003 001 001 000 000 22 23 795 507 326 262 170 112 074 049 040 033 022 015 010 007 006 005 003 002 001 000 000 000 23 24 788 492 310 247 158 102 066 043 035 028 019 013 008 006 005 004 003 002 001 000 000 000 24 25 780 478 295 233 146 092 059 038 030 024 016 010 007 005 004 003 002 001 001 000 000 000 25 26 772 464 281 220 135 084 053 033 026 021 014 009 006 004 003 002 002 001 000 000 000 000 26 27 764 450 268 207 125 076 047 029 023 018 011 007 005 003 002 002 001 001 000 000 000 000 27 28 757 437 255 196 116 069 042 026 020 016 010 006 004 002 002 002 001 001 000 000 000 000 28 29 749 424 243 185 107 063 037 022 017 014 008 005 003 002 002 001 001 000 000 000 000 000 29 30 742 412 231 174 099 057 033 020 015 012 007 004 003 002 001 001 001 000 000 000 000 000 30 35 706 355 181 130 068 036 019 010 008 006 003 002 001 001 000 000 000 000 000 000 000 000 35 40 672 307 142 097 046 022 011 005 004 003 001 001 000 000 000 000 000 000 000 000 000 000 40 45 639 264 ill 073 031 014 006 003 002 001 001 000 000 000 000 000 000 ODO 000 000 000 000 45 50 608 228 087 054 021 009 003 001 001 001 000 000 000 000 000 000 000 000 000 000 000 000 50 Source: Gittinger (1973, pp. 102-03). COMPOUNDING AND DISCOUNTING TABLES 7. Three-decimal Table for Present Worth of an Annuity Factor, Various Rates PRESENT WORTH OF AN ANNUITY FACTOR- How much 1 received or paid annually for X years is worth today. Year 1% 3% 5% 6% 8% 10% 12% 14% 15% 16% 18% 20% 22% 24% 25% 26% 28% 30% 35% 40% 45% 50% Year 1 990 971 952 943 926 909 893 877 870 862 847 833 820 806 800 794 781 769 741 714 690 667 1 2 1 970 1 913 1 859 1833 1783 1736 1690 1647 1626 1605 1566 1528 1492 1457 1440 1424 1392 1361 1289 1224 1165 1 111 2 3 2941 2829 2723 2673 2577 2487 2402 2322 2283 2246 2174 2106 2042 1981 1952 1 923 1868 1816 1696 1589 1493 1 407 3 4 3902 3717 3546 3465 3312 3 170 3037 2914 2855 2798 2690 2589 2494 2404 2362 2320 2241 2166 1997 1849 1 720 1 605 4 5 4 853 4580 4329 4212 3993 3791 3605 3433 3352 3274 3127 2991 2864 2745 2689 2635 2532 2436 2220 2035 1 876 1 737 5 6 5795 5417 5076 4917 4623 4355 4111 3 889 3784 3685 3498 3326 3167 3020 2951 2885 2759 2 643 2385 2168 1983 1824 6 7 6728 6230 5786 5582 5206 4868 4564 4288 4 160 4039 3812 3605 3416 3242 3 161 3083 2937 2802 2508 2263 2057 1883 7 8 7652 7020 6463 6210 5747 5335 4968 4639 4487 4344 4078 3837 3619 3421 3329 3241 3076 2925 2598 2331 2104 1 922 8 9 8566 7786 7 108 6802 6247 5759 5328 4946 4772 4607 4303 4031 3786 3566 3463 3366 3184 3019 2665 2379 2 144 1948 9 10 9471 8530 7722 7360 6710 6145 5650 5216 5019 4833 4494 4192 3.923 3682 3.571 3465 3269 3092 2715 2414 2168 1 965 10 11 10 368 9253 8306 7 687 7 139 6495 5938 5453 5234 5029 4656 4327 4035 3776 3656 3543 3335 3 147 2752 2438 2 185 1 977 11 12 11 255 9954 8863 8384 7 536 6814 6 194 5660 5421 5197 4793 4439 4 127 3851 3725 3606 3387 3190 2779 2456 2 196 1 985 12 13 12 134 10635 9394 8853 7904 7103 6424 5842 5 583 5342 4910 4533 4203 3912 3-780 3656 3427 3223 2799 2469 2204 1 990 13 14 13004 11296 9899 9295 8244 7 367 6628 6002 5724 5468 5008 4611 4265 3962 3824 3695 3459 3249 2814 2478 2210 1993 14 1 13865 11 938 10380 9712 8559 7606 6811 6142 5847 5575 5092 4675 4315 4001 3859 3726 3483 3268 2825 2484 2214 1995 15 16 14718 12561 10838 10106 8851 7824 6974 6265 5954 5668 5162 4730 4357 4033 3887 3751 3503 3283 2834 2489 2216 1 997 16 17 15562 13166 11274 10477 9122 8022 7 120 6373 6047 5749 5222 4775 4391 4059 3910 3 771 3518 3295 2840 2492 2218 1998 17 18 16398 13754 11690 10828 9372 8201 7250 6467 6128 5818 5273 4812 4419 4080 3928 3786 3529 3304 2844 2494 2219 1999 18 19 17226 14324 12085 11 158 9604 8365 7366 6550 6198 5877 5316 4843 4442 4097 3942 3799 3539 3311 2848 2496 2220 1999 19 20 18046 14 877 12462 11470 9818 8514 7469 6623 6259 5929 5353 4870 4460 4110 3954 3808 3546 3316 2850 2497 2221 1 999 20 21 18857 15415 12821 11764 10017 8649 7562 6687 6312 5973 5384 4891 4476 4121 3963 3816 3551 3320 2852 2498 2221 2000 21 22 19660 15937 13 163 12042 10201 8772 7645 6743 6359 6011 5410 4909 4488 4130 3970 3822 3556 3323 2853 2498 2222 2000 22 23 20 456 16444 13489 12303 10371 8883 7 718 6792 6399 6044 5432 4925 4499 4137 3976 3827 3559 3325 2854 2499 2222 2000 23 24 21 243 16936 13799 12550 10529 8985 7784 6835 6434 6073 5451 4937 4507 4143 3981 3831 3562 3327 2855 2499 2 222 2000 24 25 22 023 17413 14094 12783 10675 9077 7843 6873 6464 6097 5467 4948 4514 4147 3985 3834 3564 3329 2856 2499 2222 2000 25 26 22795 17877 14375 13003 10810 9161 7896 6 906 6491 6118 5480 4956 4520 4151 3988 3837 3566 3330 2856 2500 2222 2000 26 27 23560 18327 14643 13211 10935 9237 7943 6935 6514 6136 5492 4 964 4524 4154 3990 3839 3567 3331 2856 2500 2222 2000 27 28 24316 18764 14898 13406 11051 9307 7984 6961 6534 6 152 5502 4970 4528 4157 3992 3840 3568 3331 2857 2500 2222 2000 28 29 25066 19188 15 141 13591 11 158 9370 8022 6983 6551 6166 5510 4975 4531 4159 3994 3841 3569 3332 2857 2500 2222 2 000 29 30 25 808 19600 15372 13765 11 258 9427 8055 7003 6566 6 177 5517 4979 4534 4160 3995 3842 3569 3332 2857 2500 2222 2000 30 35 29409 21487 16374 14498 11655 9644 8 176 7070 6617 6215 5539 4992 4541 4164 3998 3845 3571 3333 2857 2500 2222 2000 35 40 32835 23115 17 159 15 046 11925 9779 8244 7 105 6642 6233 5548 4997 4544 4166 3999 3846 3571 3333 2857 2500 2222 2 000 40 45 36095 24519 17774 15456 12108 9863 8283 7123 6654 6242 5552 4999 4545 4166 4000 3846 3571 3333 2857 2500 2222 2000 45 50 39 196 25730 18256 15762 12233 9915 8304 7 133 6661 6246 5554 4999 4545 4167 4000 3846 3571 3333 2857 2500 2 222 2 000 50 Source: Gittinger (1973, pp. 104-05). ��+ _� � � : ��„ ��., - .� ..�. �;, �. ,, ,� � .__ . �„""``_ .��,�� ~ = .° � _ _ -- �� , ��' � _ �� а - ..- - � �;,,,;г ,�.� . , ,. � �� r _ . � � -.. �,. � т `� � : � � ,fi;. "`"'�,й � - � г .д,� � �' _ .� ' _ tJ ` ' /. ' " _ г .�. � _�7r '•�� 1�?G_ �_ ' 1в' %� �'� �,rc _,.�Jt.�.� ,г l `V�iц,,'У' 'fЬ# ,� • ��'�} � ��.,' �L.ae д � л� •�_?�+�: �� • ��-` ��}ь .. . лу A•� - �. � �� г . .'r .АS ��'1,� � � S '�,• �•�� ' " rY. _ з ��л ��-,`� - �"�, w _ � .' !!�� - t � �� 511F. I• ^1�� k ц,( __ � ы � 1 \ •t � г �,��д.,.� � , i � . ... �^. - , '�� а , - - +, ' �w � . � � � • � - --- ,� � ы аьг� 'tia_ � - � - �� . � �"� f -•�tч;,, � � � � ;а �fi q i :��'Я г _ •:��f�� kf ' � .гд{г � ''�;',�r';�,t'..rr� , � ..,=п'Ii;;,,/iг'' Appendix C Sources of Institutional Assistance for Project Preparation FOR SPECIALIZED ASSISTANCE in preparing complex agricultural projects, many governments may wish to turn to one of the bilateral or multilat- eral international aid agencies or to engage the services of commercial consultants. Bilateral Assistance Some governments may have a special interest in assisting developing countries to prepare particular projects. Information about bilateral assistance of this kind may be obtained from the embassy or equivalent office of the prospective donor country. Multilateral Assistance In addition to assistance agreed on by two governments, a government can enter into arrangements for assistance in preparing projects with a variety of international agencies. Facing page: Cultivating sweet potatoes in Jamaica. 437 438 APPFNDIXES European Community The European Community through the European Development Fund provides financial aid and technical assistance to sixty-one developing countries that are signatories to the Lome Convention and to some twenty-seven other countries with which it has special agreements. It is the task of the recipient country to prepare projects intended for assis- tance from the Community, but Community funds may be used to finance studies of, or technical assistance for, project preparation. More informa- tion about assistance for preparing projects may be obtained from the European Community delegation in Lome Convention countries and in seven North African and Middle Eastern countries, or from the Director- ate General for Development of the Commission of the European Com- munities in Brussels. The Commission has prepared two documents intended as guides, Appraisal of Productive Projects in Agriculture: Eco- nomic Analysis and Rate of Return (1 980a) and the Manual for Preparing and Appraising Project Dossiers (1980b). United Nations Development Programme Within the United Nations system, the principal source of technical assistance, including help for project preparation, is the United Nations Development Programme (UNDP). The UNDP finances preinvestment ac- tivities, including surveys of physical resources and of better ways to use them; analyses of national economic sectors, including agriculture, as a basis for formulating coordinated investment programs or for defining priorities; feasibility studies of investment projects; applied research; manpower training; technical education; and the like. As a rule, the UNDP does not itself carry out the preinvestment activities it finances. Instead, it turns to executing agencies-the United Nations Office of Technical Cooperation, the specialized agencies of the United Nations, the World Bank, regional development banks, and occasionally other institutions. In agriculture, the Food and Agriculture Organization (FAo) normally has been the executing agency. The World Bank has on occasion taken this responsibility, generally in such cases as credit proj- ects for which the World Bank has special experience to offer. Each developing country that wishes to take advantage of UNDP assis- tance works out an agreed "Country Programme" that identifies the sectors or activities for which assistance will be used and estimates the amounts needed. This program can be modified by the country in con- sultation with the UNDP as new information becomes available about the feasibility, priority, content, timing, and required resources for each activity. Most activities undertaken with UNDP assistance require govern- ment contributions, either in kind or in local currency. Once it is agreed that assistance for preparing a particular project will be included in the country program, a tripartite agreement is drawn up between the country receiving assistance, the UNDP, and the executing INSTITUTIONAL ASSISTANCE FOR PROJECT PREPARATION 439 agency. This specifies the arrangements for carrying out the activity, details of the reports to be prepared, provision for suspension and ter- mination, and details of the financial contributions provided by the UNoP and the government concerned. More information about assistance for preparing particular projects may be obtained from the UNDP resident representative stationed in most developing countries. The representative can also make available copies of many UNDP preinvestment and feasibility studies that provide exam- ples for those considering similar activities. Food and Agriculture Organization-development bank cooperative programs The FAO has established an Investment Centre staffed by a team of multidisciplinary experts who specialize in the formulation of invest- ment projects. The center helps to identify and prepare agricultural projects in close cooperation with the World Bank, the Inter-American Development Bank, the Asian Development Bank, the African Develop- ment Bank, the International Fund for Agricultural Development, and several Arab funds. It also has cooperative programs with national banks and financing institutions in developing countries under the FAo/Bankers Programme. The Investment Centre is especially useful for bringing to bear a com- parative knowledge of similar projects in different countries under roughly comparable conditions and for its familiarity with the special requirements of lending institutions. Usually the Investment Centre helps with project identification and preparation in two distinct stages. The first is a preliminary view of the possible project to gain an idea immediately of what activities should or should not be included, to assess the information that is available or would have to be obtained to prepare a sound analysis, to gain an idea of the administrative and organizational problems, and to be sure a project has appropriate prior- ity within the overall development program of the country. An identifica- tion mission generally remains in the country about three weeks. If a government then wishes further assistance, the Centre may provide specialists to help with project preparation. At this stage the technicians assist in preparing detailed critical analyses of the technical, financial, and economic data and assumptions. The Centre's specialists help mar- shall the available data for the financial and economic analysis and for preparing the project for presentation to the financing agency. The time needed for project preparation, of course, is dependent upon the com- plexity of the project, and the Centre may send several missions to a country in connection with the project preparation, particularly if there are serious data gaps. The simplest way for a country to obtain assistance under these FAO- bank cooperative programs is to make direct application to the FAO or to the appropriate bank. This may be done either formally to the Director 440 APPENDIXES General of the FAO through the FAo representative in the country, or informally to the director of the FAO Investment Centre directly or through an FAO or bank staff member. The application may be made by letter or by personal contact at convenient opportunities such as the visit of a,staff member of the appropriate agency to the country, bank annual meetings, FAO conferences, and the like. There is no fixed timetable for considering and approving applications for assistance, although in the nature of the activity there is generally a considerable lag between the first letter or conversation and the time the project is actually ready for work to begin. It is therefore important to make contacts early and to provide as much background information as possible on the project proposed. In the case of FAO-bank cooperative programs, the major portion of the cost is usually borne by the international agencies, but in some instances the government involved may be asked to provide local transport and similar services. World Bank Under certain circumstances, World Bank assistance may be available to help with project identification and preparation. World Bank economic missions, sector survey missions, operational missions, and resident missions may bring to a government's attention projects that seem to offer prospects for good returns. Project supervision missions by Bank staff members in the course of work on particular projects may identify later stages of ongoing projects or similar projects for possible investment. Once potential projects have been identified, the World Bank in some instances is able to assist in preparation. (World Bank assistance of any form in preparing a project does not, however, constitute a commitment of Bank financing for the resulting project.) The Bank may advise on the planning of feasibility studies-specifying the information that has to be gathered (often by providing questionnaires), defining the studies needed to obtain this information, establishing the relative priority and empha- sis to be given to different aspects of the studies, and advising about how these studies can best be organized and presented and, when appropri- ate, financed. In the later stages of preparation, the Bank may also help ensure that the feasibility study is progressing along the right lines and that it will cover the necessary aspects. This assistance may range from occasional visits by Bank staff to the formal participation of Bank staff in steering committees. Sometimes the World Bank also finances project preparation studies undertaken either by government agencies or by commercial consul- tants. World Bank financing for a project may include funds for prepar- ing subsequent phases or additional related projects. In a few cases when a large number of potential projects needed study and preparatory work, a separate loan for technical assistance has been extended. INSTITUTIONAL ASSISTANCE FOR PROJECT PREPARATION 441 Member countries of the World Bank can occasionally make use of the World Bank's Project Preparation Facility to finance preparation of proj- ects expected to be presented for Bank financing. This assistance is only extended when other alternatives for financing the preparation either are not available or require excessive administrative effort. Funds advanced under this arrangement are repaid from loan or grant proceeds if a loan or grant is made or over a five-year period if the project is not financed by the World Bank. The facility is usually available only to poor countries that could not reasonably be expected to finance the activities from their own resources pending reimbursement out of an eventual loan or grant. The funds may be used to provide additional support for the group responsible for preparing the project or to finance gaps in the project preparation that must be filled before the project can be appraised by the Bank. Examples of the kinds of omission that these funds could be used to rectify include inadequate economic analysis, incomplete market studies, omission of a monitoring system, the need for more complete information about land tenure in the project area, or unforeseen environ- mental implications of the project that require further study. Consultants Many governments will want to engage either individual consultants or consulting firms to assist with project preparation. Sometimes assis- tance will be sought for only a particular aspect of project preparation, other times for the entire preparation. The United Nations Industrial Development Organization (UNIDo) has prepared an extremely useful Manual on the Use of Consultants in Developing Countries (1972b). This contains many helpful suggestions about how to select, engage, and use consultants, especially consulting firms. The World Bank (1981c) has prepared a pamphlet that outlines its own approach to the use of consul- tants and the use of consultants by governments in connection with Bank-financed projects, as has the Inter-American Development Bank (1981). There are many reasons why governments may wish to turn to consul- tants. Many government agencies are already fully occupied and simply do not have the time to devote to proper project preparation. External help can be brought in that can devote its full attention to preparing the project within a specified time. Required skills or specialized know-how may not be available in the country. A problem may arise that calls for the attention of specialists, but it is not expected to repeat itself-hence, it is not worth developing local expertise in the area. Even when the overall project preparation is to be carried out by a government agency, there may be special technical assessments for which outside expertise is desirable-an analysis of soils for an irrigation project, a market analysis for a specialty crop grown for export, or chemical tests on tree species that might be planted for pulpwood. Consultants may be able to use a 442 APPENDIXES new or more up-to-date approach in solving problems. They may also be used to provide an outside, impartial view or may be asked for an independent second opinion. Consultants may be sought from a variety of sources. Many times an individual or a particular firm will have done similar work previously, and a government may wish to engage the services again. Local consul- tants or consulting firms may already be well known. Individual consul- tants may come from local universities. The UNIDO Manual on the Use of Consultants has a list of professional consulting associations that will make suggestions about possible consultants. Embassies often have lists available of consultants in their countries. The World Bank maintains lists of individuals and firms that have expressed an interest in consult- ing, but does not keep a list of "approved" consultants. The Bank's general files on consulting firms are available to visiting representatives from Bank borrowers or member governments who need to review and assess the experience and qualifications of consulting firms they are considering for projects. An increasing number of national consulting firms of suitable compe- tence exist in developing countries. More might grow if more govern- ments were to adopt a conscious policy to encourage them and to assure them an opportunity to compete for suitable work. When national con- sulting firms are used instead of government agencies, the advantages of having a group of people who can focus on project preparation without the pressures of day-to-day routine administration are realized. At the same time, the specialized skills that such consultants gain in the course of their work remain in the country and can be available again in the future. In cases where a national consulting firm does not have the full range of expertise needed to prepare a project, the national firm can often draw upon a foreign associate for particular specialized skills and use its own resources for less esoteric work. Such links between local and for- eign firms are increasingly common in the consulting field. Retaining overall control in local hands means that local conditions can be fully considered while foreign expertise is utilized. Sometimes, however, national firms simply will not have enough of the skills needed to prepare certain kinds of projects, and a government will have to turn to an international consulting firm. When this happens, the terms of reference for the foreign consultant may provide for an association with a local firm and include a planned training program. Through their association with the foreign consulting firm, the national consultants can increase their expertise. Then, as similar projects are prepared in the future, the involvement of the foreign firm can decrease until the national firm is able to undertake these kinds of consulting assignments entirely on its own. A frequent concern about the use of consultants is the cost. Often the fees of consultants, especially those from abroad, seem very high com- pared with government salary scales in the country. One way to reduce the cost of consulting services may be to rely more on qualified local consultants. In the final analysis, however, if an individual consultant or INSTITUTIONAL ASSISTANCE FOR PROJECr PREPARATION 443 a consulting firm can prepare a sizable project well, even what seems a rather high consulting fee may not be unreasonable. Of course, care must be taken to ensure that any consulting fees asked are reasonable given the complexity of the project and the amounts charged for similar work in other instances. Nonetheless, as the UNIDO Manual on the Use of Consul- tants states, "a good job is well worth the cost, and a poor one is a loss, regardless of price" (1972b, p. 19). The cost of consulting services to prepare an agricultural project seldom amounts to more than 5 to 10 percent of the project cost. As the UNIDO Manual notes, a saving of, say, 10 percent on consulting fees means no more than a saving of 1 percent on the project cost. But poor consulting services and bad engineering can lead to very substantial cost overruns (1972b, ibid.). � _ � , r �� _ �$ `„�, `.,,�т з И � � г . � �� >: � � ,у� � �- �� ..._ - � �... � �,� . �. -_ ;- г ��у � i, � �=� z+в'• �� _ � . �� ^�" J g �� . �..�+� ' '�, �� '/ i�' / ..�" - ддд � r� � �. � ,+ . , __ � � � : �?. € _ � i1�' '�Or Т , ' � _ t 6 � � � � i� �G �' /ь1; 1� ;` • � _ � ,• '' .l ! � 1 � � �l�P' � �� 'г , г 1 � . _ S. � � Ъ � � f _ ' �� 1• �� - _ 1 � � _ � � ` 1 . ' � :,� 4 ! д Ч _ � � � � t � � ., � �� .J � . � S ] �� _- ___' ' . !. � 1 �4 1 i у "` • � � � , � ' � �.`� � �. � � . _ _ '' ; �� . -- �� i п�! ¢. �� ' , т �- у " �� А� V � � у� - . � 1 Bibliography Adler, Hans A. 1971. Economic Appraisal of Transport Projects: A Manual with Case Studies. Bloomington: Indiana University Press. An introductory manual focusing on transport projects that include rural roads. Includes case examples. Austin, James E. 1981. Agroindustrial Project Analysis. Baltimore, Md.: Johns Hopkins University Press. A very useful discussion of the elements of formulating projects for industries that use agricultural raw materials. The emphasis is more on the project design than on narrow methodological considerations. Bacha, Edmar, and Lance Taylor. 1972. "Foreign Exchange Shadow Prices: A Critical Review of Current Theories." In Benefit Cost Analysis 1971, edited by Arnold C. Harberger and others, pp. 29-59. Chicago: Aldine-Atherton. A comprehensive, formal review of the theory of foreign exchange shadow prices. Bannock, G., R. E. Baxter, and R. Rees. 1972. The Penguin Dictionary of Eco- nomics. Harmondsworth, U.K.: Penguin Books. A standard reference for economic terms. Barnum, Howard N., and Lyn Squire. 1979. A Model ofan Agricultural Household: Theory and Evidence. Baltimore, Md.: Johns Hopkins University Press. Facing page: Carrying rice straw from the field in Bangladesh. 445 446 BIBLIOGRAPHY Discusses in considerable detail the economics of rural labor supply in a developing country. Baum, Warren C. 1978. "The Project Cycle." Finance and Development, vol. 15, no. 4 (December), pp. 10-17. Also available in pamphlet form (1982) from the World Bank. An updated version of an earlier article that established "project cycle" as a concept in development economics. Benjamin, McDonald P. 1981. The Making ofan Agricultural Project: Principles and Case Studies. London: Longman. Traces the process of identifying and preparing an agricultural project. Bergmann, Hellmuth, and Jean-Marc Boussard. 1976. Guide to the Economic Evaluation of Irrigation Projects. Rev. version. Paris: Organisation for Eco- nomic Co-operation and Development (OECD). Focusing entirely on irrigation projects, this work devotes considerable atten- tion to the data needed for project evaluation. The analytical method advanced is somewhat different from, but is not incompatible with, that outlined in this book. An interesting set of blank tables for presenting the results of the analysis is included. Well worthwhile for those working on irrigation investments. Bierman, Harold, Jr., and Seymour Smidt. 1980. The Capital Budgeting Decision. 5th ed. New York: Macmillan. Good introductory text on investment analysis; intended more for engineering and industrial than for agricultural applications. Bigg, W. W., and R. E. G. Perrins. 1971. Spicer and Pegler's Bookkeeping and Accounting. 17th rev. ed. London: English Language Book Society and H.F.L. (Publishers) Ltd. A standard, university-level introductory text on accounting. Brown, David W., William F. Litwiller, and Frank Fender. 1974. Manual for Agricultural Capital Project Analysts. Washington, D.C.: U.S. Department of Agriculture, Economic Research Service. Traces the steps in formulating and presenting an agricultural project. Com- plementary to this book. Brown, Maxwell L. 1979. Farm Budgets: From Farm Income Analysis to Agri- cultural Project Analysis. Baltimore, Md.: Johns Hopkins University Press. A basic text discussing in detail preparation of farm budgets for use in agri- cultural project analyses, including concepts of farm income, partial budgets, farm models, livestock projections, and aggregation. Bruce, Colin M. F. 1976. Social Cost-Benefit Analysis: A Guide for Country and Project Economists to the Derivation and Application of Economic and Social Accounting Prices. World Bank Staff Working Paper no. 239. Washington, D.C. Explains the derivation of national parameters used to estimate distributional accounting following the methodology of Squire and van der Tak (1975). It contains a very useful set of worksheets and illustrates their application in Thailand. - -. 1980. "The Stages of Project Planning-An Introduction to Project Plan- ning." CN-301. Washington, D.C.: Economic Development Institute (EDI), World Bank. BIBLIOGRAPHY 447 Introduces the reader to the concepts and purposes of the various stages of project planning through analysis of the nature of planning; discusses the significance and importance of the various stages; and stresses the need for an acceptance of a project planning system with the political, institutional, and methodological components that make for an effective system. Bruno, Michael. 1967. "The Optimal Selection of Export-Promoting and Import- Substituting Projects." In Planning the External Sector: Techniques, Problems, and Policies. Report on the First Interregional Seminar on Development Plan- ning, Ankara, Turkey, 6-17 September 1965, pp. 88-135. ST/TAO/SER.c/91. New York: United Nations. A thorough summary of the theoretical and practical problems associated with computing domestic resource cost. Carnemark, Curt, Jaime Biderman, and David Bovet. 1976. The Economic Analy- sis of Rural Road Projects. World Bank Staff Working Paper no. 421. Washing- ton, D.C. A discussion of the analytical procedures to apply to rural roads that have low levels of traffic. Emphasizes the interdependence of transport and agricultural production systems in the rural environment and suggests that the analysis should focus on the mechanisms by which transport cost savings are translated into increasing agricultural production and income. Carruthers, Ian, and Colin Clark. 1981. The Economics of Irrigation. Liverpool: Liverpool University Press. Focuses on irrigation; includes much material dealing with the technical, institutional-organizational-managerial, financial, and economic aspects of irrigation projects. Commission of the European Communities. 1980a. Appraisal of Productive Proj- ects in Agriculture: Economic Analysis and Rate of Return. VIII/701/76 Rev. 4. Brussels. Brief discussion of financial and economic analysis, with particular attention given to the "basic principles to be followed in the economic and financial analysis of the agricultural projects submitted to the Commission for financ- ing." Includes a case study intended as a guide for preparing projects. -. 1980b. Manual for Preparing and Appraising Project Dossiers. VIII/527/ 79-EN. Brussels. Outlines are given for projects dealing with general agriculture, livestock, rural roads, rural industries, rural health, rural education, sites and services, slaughterhouses, drinking water supply, and drainage. Delp, Peter, and others. 1977. "Systems Tools for Project Planning." Blooming- ton: Indiana University, International Development Institute, Program of Ad- vanced Studies in Institution Building and Technical Assistance Methodology. Discusses a range of tools for planning and analyzing projects, including many tools suitable for use when quantification is difficult. Eckstein, Otto. 1958. Water Resource Development: The Economics of Project Evaluation. Cambridge, Mass.: Harvard University Press. A theoretical discussion of the issues and problems of project analysis. Classic in its field, but stiff going (written for professional economists). 448 BIBLIOGRAPHY Espadas, Orlando T. 1977. "Herd Projection Using Hewlett-Packard 67 Calcula- tor." CN-3 1. Washington, D.C.: Economic Development Institute, World Bank. Contains the program and detailed instructions about how to use a program- mable calculator for herd projections. Estes, Ralph. 1981. Dictionary of Accounting. Cambridge, Mass.: MIT Press. Convenient, up-to-date reference on accounting terms helpful for those doing financial analysis of projects. Food and Agriculture Organization (FAO), FAo/World Bank Cooperative Pro- gramme. 1975. Guidelines for the Preparation of Feasibility Studies: Rural De- velopment Projects. Rome. See next reference for comment. , Investment Centre. 1977. Guidelines for the Preparation of Agricultural Investment Projects. Rome. Two of a series of guidelines for various kinds of agricultural projects prepared by the FAO Investment Centre. Gittinger, J. Price, ed. 1973. Compounding and Discounting Tables for Project Evaluation. Baltimore, Md.: Johns Hopkins University Press. Basic financial tables prepared with the needs of projects analysts in mind. Includes six-decimal tables for 1 percent through 50 percent by whole percent- age points for compounding factor for 1, compounding factor for 1 per annum, sinking fund factor, discount factor, present worth of an annuity factor, and capital recovery factor; summary present worth tables; narrow-interval com- pounding tables for compounding factor for 1 by intervals of tenths of 1 percent from 0.0 percent through 10.9 percent; and a discussion with examples of how to use the tables. Gittinger, J. Price, Prem C. Garg, and Alfred Thieme. 1982. "Current Use of Project Analysis Tools in the World Bank and the Inter-American Development Bank." CN-86. Washington, D.C.: Economic Development Institute, World Bank. A review of the application of project analysis tools in projects financed by the World Bank and the Inter-American Development Bank (IDB) during 1981. Grant, Eugene L., and W. Grant Ireson. 1964 (4th ed.) and 1970 (5th ed.). Princi- ples of Engineering Economy. New York: Ronald. A standard, thorough text in the field that discusses many questions of applica- tion. Greenwald, Douglas, ed. 1982. Encyclopedia of Economics. New York: McGraw- Hill. Extensive list of economics terms with substantial discussion and references. Gregerson, Hans M., and Arnoldo H. Contreras. 1979. Economic Analysis of Forestry Projects. FAO Forestry Paper no. 17. Rome: Food and Agriculture Orga- nization. Discusses many of the same concepts dealt with in this book, but with forestry examples. Limited to economic analysis only. Hansen, John R. 1978. Guide to Practical Project Appraisal: Social Benefit-Cost Analysis in Developing Counties. Project Formulation and Evaluation Series no. 3. Sales no. E.78.II.B.3. New York: United Nations. BIBLIOGRAPHY 449 Provides an excellent introduction to the United Nations Industrial Develop- ment Organization (UNIDO) Guidelines forProject Evaluation (1 972a). Especially useful for noneconomists. Hardie, J. D. M. 1976. A Guide to Basic Agricultural Project Appraisal in Developing Countries. Miscellaneous Publication no. 12. Aberdeen, U.K.: University of Aberdeen, School of Agriculture. An introductory text written to meet the needs of junior staff in developing countries. Harsh, Stephen B., Larry J. Connor, and Gerald D. Schwab. 1981. Managing the Farm Business. Englewood Cliffs, N.J.: Prentice-Hall. A contemporary farm management text. Helmers, F. Leslie C. H. 1979. Project Planning and Income Distribution. Boston: Martinus Nijhoff. Excellent review and critique of project analysis theory and practice. Pre- sented in language of formal economics. Inter-American Development Bank (IDB). 1978. "Guidelines for the Preparation of Loan Applications." Washington, D.C. Comprehensive and detailed outlines for agricultural projects including rural credit, forestry, integrated rural development, research and extension, agro- industry, livestock development, marketing of agricultural products, and irrigation. At present, most outlines are available in Spanish only. . 1981. Use of Consulting Firms by the IDB and Its Borrowers. Washington, D.C. Describes the selection and supervision process, policies, and procedures relat- ing to use of services of consulting firms and individual consultants by the Inter-American Development Bank and its borrowers. Irvin, George. 1978. Modern Cost-Benefit Methods. An Introduction to Financial, Economic, and Social Appraisal of Development Projects. London: Macmillan. Excellent university-level, introductory text that focuses on methodological issues. Discusses measures of project worth and economic valuation in detail and compares proposed systems of distribution weights. James, L. D., and R. R. Lee. 1970. Economics of Water Resources Planning. New York: McGraw-Hill. Includes a detailed discussion of the separable costs-remaining benefits method of joint cost allocation. Kalbermatten, John M., DeAnne S. Julius, and Charles G. Gunnerson. 1982. Appropriate Sanitation Alternatives: A Technical and Economic Appraisal. Balti- more, Md.: Johns Hopkins University Press. Chapter 3 contains a discussion of cost-effectiveness analysis. Kay, Ronald D. 1981. Farm Management: Planning, Control, and Implementation. New York: McGraw-Hill. A contemporary farm management text with emphasis on the management process. King, John A., Jr. 1967. Economic Development Projects and Their Appraisal. Baltimore, Md.: Johns Hopkins University Press. An early, descriptive presentation of World Bank projects. 450 BIBLIOGRAPHY Krishna, Raj. 1967. "Agricultural Price Policy and Economic Development." In Agricultural Development and Economic Growth, edited by Herman M. South- worth and Bruce F. Johnston, pp. 497-540. Ithaca, N.Y.: Cornell University Press. A standard summary of research showing that farmers in developing countries are price responsive. Although data are now dated, the conclusions remain valid and the evidence is among the most clearly laid out available. Kulp, Earl M. 1977. "Designing and Managing Basic Agricultural Programs." Bloomington: Indiana University, International Development Institute, Pro- gram of Advanced Studies in Institution Building and Technical Assistance Methodology. Presents in detail a system for planning and preparing agricultural projects. Kutcher, Gary P., and Pasquale L. Scandizzo. 1981. The Agricultural Economy of Northeast Brazil. Baltimore, Md.: Johns Hopkins University Press. An example of a programming model applied to agricultural sector planning. Lee, James A., coordinating author. 1982. The Environment, Public Health, and Human Ecology: Considerations for Economic Development. Washington, D.C.: World Bank. Discusses the identification and measurement of the effects agricultural and other development projects can have on the environment and human health; includes suggestions about how to avoid or mitigate the undesirable effects through appropriate project design and preparation. Lieftinck, Pieter, A. Robert Sadove, and Thomas C. Creyke. 1968. Water and Power Resources of West Pakistan. 3 vols. Baltimore, Md.: Johns Hopkins University Press. An example of a programming model applied to agricultural sector planning. Little, I. M. D., and J. A. Mirrlees. 1974. Project Appraisal and Planning for Developing Countries. New York: Basic Books. Extremely influential book on project analysis that presents many seminal ideas. Written for the professional economist. Loughlin, James C. 1977. "The Efficiency and Equity of Cost Allocation Methods for Multipurpose Water Projects." Water Resources Research, vol. 13, no. 1 (February), pp. 8-14. Proposed modifications of the separable cost-remaining benefits method of joint cost allocation to increase equity through weighting for the relative amounts of the separable costs assigned to each purpose. McDiarmid, Orville John. 1977. Unskilled Labor for Development: Its Economic Cost. Baltimore, Md.: Johns Hopkins University Press. Discusses in detail concepts of the economic value of labor and applies these concepts to the economies in East and Southeast Asia. McKean, Ronald N. 1958. Efficiency in Government through Systems Analysis with Emphasis on Water Resources Development. New York: Wiley. A classic in the field that clearly sets forth the issues. Recommends use of internal rate of return rather than benefit-cost ratio. Mears, Leon A. 1969. Economic Project Evaluation with Philippine Cases. 2 vols. Quezon City: University of the Philippines Press. BIBLIOGRAPHY 451 A basic text, with cases written for teaching in the Philippines-hence, quite applicable in many South and Southeast Asian nations. Merrett, A. J., and Allen Sykes. 1963. The Finance and Analysis of Capital Projects. London: Longman. Excellent and thorough text on techniques of project analysis, with emphasis on application for private firms. Particularly good for questions of method- ology. Meyn, Klaus, J. Price Gittinger, and Walter Schaefer-Kehnert. 1980. "Herd Pro- jection Exercise. Paraguay: Livestock and Agricultural Development Project." AE-l 124-P. Washington, D.C.: Economic Development Institute, World Bank. A paper recommending a standardized approach to preparation of herd projec- tions; illustrated by the example from the Paraguay Livestock and Agricultural Project used in chapter 4 of this book. Mishan, E. J. 1971. "The Postwar Literature on Externalities." Journal of Eco- nomic Literature, vol. 9, no. I (March), pp. 1-28. A highly technical summary of the literature on secondary effects; focuses primarily on the relation of benefits to individual firms rather than to society as a whole. Mishra, S. N., and John Beyer. 1976. Cost-Benefit Analysis: A Case Study of the Ratnagiri Fisheries Project. Delhi: Hindustan Publishing Corp. Interesting application of benefit-cost analysis to a fisheries project. Mulvaney, John. 1969. Analysis Bar Charting: A Simplified Critical Path Analysis Technique. Bethesda, Md.: Management Planning and Control Systems, Inc. (5825 Rockmere Drive, Md. 20817, U.S.A.). Excellent, introductory text on critical path analysis technique. Uses "prece- dence diagramming," a method that puts activities into boxes and uses arrows to connect them; the method is more readily understood than conventional techniques using arrows to indicate activities. Niswonger, C. Rollin, and Philip E. Fess. 1977. Accounting Principles. 12th ed. Cincinnati, Ohio: South-Western. Thorough text on accounting following American conventions. Norton, Roger D., and Leopoldo Solis M. 1982. The Book of CHAC: Programming Studies for Mexican Agriculture. Baltimore, Md.: Johns Hopkins University Press. An example of a programming model applied to agricultural sector planning. Olivares, Jose. 1978. "Evaluacion retrospectiva de proyectos agricolas" [Retro- spective evaluation of agricultural projects]. Washington, D.C.: World Bank. Restricted circulation. A discussion of World Bank agricultural project experience and reasons why some projects fall short of expectations. Packard, Philip C. 1974. Project Appraisal for Development Administration. The Hague: Mouton. Discusses the methodology of project analysis by referring to illustrative cases drawn from agroindustrial projects in developing countries. Pouliquen, Louis Y. 1970. Risk Analysis in Project Appraisal. Baltimore, Md.: Johns Hopkins University Press. 452 BIBLIOGRAPHY Applies formal risk analysis techniques, which require machine computation, primarily to problems of transport and public utility projects. Discusses issues of suitable techniques for applying risk analysis. Powers, Terry A. 1975. HERDSIM Simulation Model: User Manual. Papers on Project Analysis no. 2. Washington, D.C.: Inter-American Development Bank. Presents and discusses a computer program for beef herd projections. Prest, A. R., and R. Turvey. 1966. "Cost-Benefit Analysis: A Survey." In Surveys of Economic Theory, vol. 3, Resource Allocation, edited by the American Eco- nomics Association and the Royal Economic Society, pp. 155-207. New York: St. Martin's. The best general survey with which to begin serious exploration of the issues relating to measures of project worth. Reutlinger, Shlomo. 1970. Techniques for Project Appraisal under Uncertainty. Baltimore, Md.: Johns Hopkins University Press. A sophisticated treatment of uncertainty; requires the use of a computer. Useful where very large investments are involved and suitable, highly skilled manpower can be assigned to the analysis. Riley, J. Paul, and others. 1978. "Cost Allocation Alternatives for the Senegal River Development Program." Water Resource Planning Series no. UWRL/ P-78/06. Logan: Utah State University, Utah Water Research Laboratory. A careful discussion of joint cost allocation issues and methodologies applied to an international project in West Africa. Ripman, Hugh. 1964. "Project Appraisal." Finance and Development, vol. 1, no. 3 (December), pp. 178-83. The first published, systematic presentation of the aspects of project analysis. Ruthenberg, Hans. 1977. "A Framework for the Planning and Evaluation of Agricultural Development Projects." Nairobi: Ministry of Agriculture, Plan- ning Division. [Available in German as Ein Rahmen zur Planung und Beur- teilung landwirtschaftlicher Entwicklungs-projeckte. 2. Auflage. Frankfurt: DLG- Verlag.] A very thorough text with considerable emphasis on preparation of projects as well as a discussion of analytical techniques. Sassone, Peter G., and William A. Schaffer. 1978. Cost-Benefit Analysis: A Hand- book. New York: Academic. Written for noneconomists, this is a direct statement of the elements of benefit- cost analysis. It is addressed to readers in developed rather than developing countries and is not intended to deal with a particular sector. Has a good, but not annotated, bibliography. Schaefer-Kehnert, Walter. 1978. "Time-Adjusted Cash Flow Projections in Farm Investment Analysis." Zeitschrift fur Auslandische Landwirtschaft [Quarterly Journal of International Agriculture], vol. 17, no. 3 (July-September), pp. 233-49. Discusses the rationale for the "time-adjusted" accounting convention for farm investment analysis and the incremental working capital as a percentage of incremental operating expenditure. . 1980. "Methodology of Farm Investment Analysis." Zeitschrift fur Auslandische Landwirtschaft [Quarterly Journal of International Agriculture], vol. 19, no. 2 (April-June), pp. 105-21; no. 3 (July-September), pp. 250-67. BIBLIOGRAPHY 453 Distinguishes farm investment analysis (benefit-cost analysis of on-farm in- vestments) from farm income analysis and funds flow analysis and describes the accounting procedures required for a time-adjusted phasing of costs and benefits. The treatment of inflation, performance criteria, and the measure- ment of small farmers' investment incentives are also discussed. -. 1981a. "Herd Projection Exercise. Tanzania Ranch." AE-1097-P. Washington, D.C.: Economic Development Institute, World Bank. A self-teaching guide to herd projections that is compatible with the farm budget accounting convention recommended in this book. -. 1981b. "How to Start an Internal Rate of Return Calculation." CN-30. Washington, D.C.: Economic Development Institute, World Bank. Discusses means to estimate the internal rate of return easily to reduce the calculation burden arising from repeated trials. Scott, M. FG., J. D. MacArthur, and D. M. G. Newbery. 1976. Project Appraisal in Practice. London: Heinemann. Applies the methodology proposed by Little and Mirrlees (1974) to selected projects in Kenya. Advanced. Shanner, W. W. 1979. Project Planning for Developing Economies. New York: Praeger. A general text on the methodology of benefit-cost analysis. The book grew out of materials prepared for university instruction. Contains an analysis of a hypothetical supplemental irrigation project. Sloan, Harold S., and Arnold J. Zurcher. 1970. Dictionary of Economics. 5th ed. New York: Barnes & Noble. A standard reference for economics terms. Squire, Lyn, and Herman G. van der Tak. 1975. Economic Analysis of Projects. Baltimore, Md.: Johns Hopkins University Press. A methodology for project analysis developed by two World Bank economists and growing from that of Little and Mirrlees (1974) and the UNIDO Guidelines (1972a). Recommends a more "systematic and consistent estimation and ap- plication of shadow prices" than had previously been common in World Bank practice as well as calculation of "rates of return that take explicit account of the impact of the project on the distribution of income both between invest- ment and consumption and between rich and poor" (p. 3). United Nations Industrial Development Organization (UNIDO). 1972a. Guidelines for Project Evaluation. Prepared by Partha Dasgupta and others. New York: United Nations. Proposes a methodology for project analysis that incorporates elements of more systematic shadow pricing and distribution weights. Along with Little and Mirrlees (1974), this work has exerted substantial influence on recent thinking about project analysis methodology. -. 1972b. Manual on the Use of Consultants in Developing Countries. New York: United Nations. Concise, comprehensive guide of immediate practical relevance to administra- tors in developing countries. U.S. Government, Water Resources Council. 1979. "Procedures for Evaluation of National Economic Development (NED) Benefits and Costs in Water Resource Planning." Federal Register, vol. 44, no. 242 (December 14), pp. 72892-976. 454 BIBLIOGRAPHY Defines costs and benefits for use by U.S. government agencies and specifies how they are to be used for evaluating water resource projects. Upper, Jack L., ed. 1979. "Finance for Project Analysis." Washington, D.C.: Economic Development Institute, World Bank. A collection of training materials that focus on financial analysis of industrial enterprises. van der Tak, Herman G. 1969. The Economic Choice between Hydroelectric and Thermal Power Developments. Baltimore, Md.: Johns Hopkins University Press. Discusses methodologies to analyze the choice between alternative technolo- gies with very different time profiles for investment and operating costs. Wall, Albert. 1979. Environment and Development. Washington, D.C.: World Bank. Discusses the relation between project investment and environmental and health problems. Ward, William A. 1976. "Adjusting for Over-Valued Local Currency: Shadow Exchange Rates and Conversion Factors." CN-28. Washington, D.C.: Economic Development Institute, World Bank. Intended for practical application in those instances where estimates by the central planning office are not available and project analysts must determine shadow exchange rates or conversion factors for themselves. Waterston, Albert, Wayne Weiss, and John L. Wilson. 1976. Managing Planned Agricultural Development. Washington, D.C.: Government Affairs Institute. A handbook intended as a source document for those responsible for preparing agricultural projects. Westley, Glenn D. 1981. FARMSIM Users Guide: A Model for the Appraisal ofFarm Development Projects. Papers on Project Analysis no. 12. Washington, D.C.: Inter-American Development Bank. Presents and discusses a computer program for appraising farm development projects. Woo, S. J. 1982. "Sources of Information on World Prices," CN-26. Washington, D.C.: Economic Development Institute, World Bank. Comprehensive listing of sources for obtaining world market prices to use in project analysis. World Bank. 1978, 1980, and 198 1a. Annual Review of Project Performance Audit Results. Washington, D.C. Analyzes the strengths and weaknesses of selected World Bank projects for which loan disbursements have been completed during the year to which the report pertains. Published annually. -. 1981 b. A Handbook on Monitoring and Evaluation ofAgricultural and Rural Development Projects. Washington, D.C. Discusses the approach to monitoring and evaluation and specific problems that may be encountered in collecting and evaluating data. -. 1981c. Guidelines for the Use of Consultants by World Bank Borrowers and by the World Bank as Executing Agency. Washington, D.C. Describes the selection and supervision process, policies, and procedures relat- ing to services of consulting firms and individual consultants used by the World Bank and its borrowers. BIBLIOGRAPHY 455 1982a. Price Prospects for Major Primary Commodities. Report no. 814/82. Washington, D.C. An authoritative and convenient projection of prices for major commodities of interest to developing countries. Published biennially in even-numbered years, with updates at six-month intervals between publications. . 1982b. "Irrigation Water Charges, Benefit Taxes, and Cost Recovery Policies." CN-88. Washington, D.C.: Economic Development Institute, World Bank. A discussion of the concepts underlying World Bank procedures for estimating cost recovery and rent recovery indexes. �4 Т � � �- � � р � . -- - � ,� --�-- . . . � а _ � � �� ' � • д �� . � �# � �� - -- i .,.'I'� �� r� г 6 � �� - .. � ,� `. � �'# �1�.�;,��,� `� � �.':л�#.�� , ,� �*N i � : � � � _ � �� t �� .� �в/ �_� �� f: '� � �� *;:�� уΡ� � �ь�;� � � г f • f � � }' ' ,� � `� �� f �� i � � � �� j, � � � L ;г l l, ,.�; �� : i . F i� ' • м ? . • �i Т �� ' , '�� t t�'4у tЭЬв � 4, 1 ♦ � �,� � � �� ;� л �уΡ ',�уΡ}{ � �f �r� Тt �' �г, гА',g�� #'� "" '. �� `1 �� з! ' �� r •й '� f' � � F (�� *�� -t k"�'��_ У1 �� _ � � �г � !� � � _ ` ��%} 44 �. �� 4 `- � `F� � 4�: , '• � �� ? п ^' 7 �•,�� ' �h • � ` �'° л � �! 7 '` ��- ,G �'� У �q� ��.� � � �� ,' ." , r � '' � � �т3�, �./''* �.fi � � �rf . ^ 4 � У Е�� 1t ,л г� , � '�ч �� t� � � _ � ,i - '.> � �,�' `'� _ " �� , � � � � �- � • �-�� 1 .f= � -- . � . �. �,� �s t Г, У ,$,�. �` . . �Т� 1 � k .� l, � ё' �уΡ-г@4��'.. ; ��`}[(�jj� �`` \\\ � "Т А� 1� �� Г �� -_ � � � � � � _ �� ,� � � .�� `*�l ?• � t� - � ` 4 �� `� �,';}'� � t ��{ � й" � �'�,�� i1J, � � ц � � � . � ,�.� �й � z �� t,ti 1 � � !�� `�� - '}� � �� -� �'"f�� -� ``��,.,.� ,�� ,�й �s �i } �`ti � �l ° \�� ь - �'� � - �` -г � � - � . � �� , ��" -,�' � � .3; .,.+b � � � -�� • � _ .� °� � � h �С�� 4ч 4 � ь � в � i г , и-'! -t�`�г, t+�t� �i � �у'' `� .�i ; � _ �\ ' Т,; с . \l � �, � t w.,�` ` � \!. д� , 1�ц ~� � _�" �, .�` t�.(г� +�,\'�4Д�� , �� i t�!��. � �уΡ' 1 \�,��.`�Vi� TTi.� :с4� bil' . 4'�:� . �� .,.в �I1 ��т 1 \�А��l � •�д: г � ` - `�i' Glossary-Index THE SPECIALIZED TERMS most frequently used in agricultural project analysis are defined in this glossary-index as they are used in this book. Definitions follow index entries and appear in italic type. When other terms that are also defined in the index are used in a definition or are cross-referenced, they appear in SMALL CAPITALS. For accounting terms pertaining to the financial aspects of project analysis, the reader may find Estes (1981) and Upper (1979) informative. For economic terms, the reader may also wish to consult Bannock, Baxter, and Rees (1972), Greenwald (1981), and Sloan and Zurcher (1970). Page numbers in italic type indicate figures or tables. Absolute value. The numerical value ofa period is generally a year, but it could real number irrespective ofsign. be any other convenient time period. Accounting convention (time-adjusted) Accounting price. See SHADOW PRICE compounding interest and, 306 Accounts discounting and, 315 aggregation methods and, 287-96 for farm investment analysis, 95-99 11 articulated," 197 financial statements and, 190 financial statements and, 190-92 herd projection and, 164-65 Accounts payable. Amounts owed by an repayment of equal amounts of princi- enterprise to the suppliers ofgoods or pal and, 151-53 services purchased on credit. Accounting period. The interval between financial rate of return calculation successive entries in an account. In and, 212 PROJECT ANALYSIS, the accounting sources-and-uses-of-funds statement 457 458 GLOSSARY-INDEX Accounts payable (continued) Alternative cost valuation. A technique and, 199 for placing monetary values on Accounts receivable. Amounts owed to INTANGIBLE BENEFITS in MULTIPURPOSE an enterprise by its customers for PROJECTs. Valid only if the alternative purchase of goods or services pro- activity would have been undertaken vided on credit. in the absence of the PROJECT. For ex- balance sheet and, 193 ample, the forgone cost of drinking financial rate of return calculation water wells may be used as a surro- and, 212 gate value for improved drinking wa- sources-and-uses-of-funds statement ter supplied by a multipurpose reser- and, 201 voir project. Used primarily in water Accrual accounting. A method of record- resources projects in the United ing accounting transactions that re- States. See INTANGIBLE cords revenues in financial statements Alto Bene Amazon Basin Project (Bra- for the period during which the re- zil), 257 venues are earned, or realized, and Alto Turi Land Settlement Project (Bra- that records expenses in the period in- zil), 49-50 curred, regardless of whether the cor- Amortization. Gradual repayment or writ- responding cash transactions took ing off of an original amount. place previously or subsequently. Dis- DEPRECIATION is a form of amortiza- tinguished from CASH BASIS tion. The CAPITAL RECOVERY factor is ACCOUNTING. composed of an INTEREST component Administrators, 3 and an amortization component. financial aspects of projects and, 18 Amount of 1. See COMPOUNDING FACTOR project performance and, 33-34 FOR I project preparation and, 422-23, 426 Amount of I per annum. See Africa COMPOUNDING FACTOR FOR I PER price policy example and, 35 ANNUM producer price example and, 35 Analysis. See ECONOMIC ANALYSIS; social environment example and, 32 FINANCIAL ANALYSIS; PROJECT ANALYSIS; African Development Bank, 219 SENSITIVITY ANALYSIS; Technical Aggregation. In PROJECT ANALYSIS, the analysis process of adding together the costs Animal unit. A standard measure of feed and benefits of all the entities partici- availability or demand. In HERD pating in a PROJECT to reach a sum- PROJECTIONS for cattle, one animal mary account from which a MEASURE unit is usually the FEED REQUIREMENT OF PROJECT WORTH can be derived. of a cow of average size in the refer- Often the result of aggregation is the ence area. incremental NET BENEFIT, or cash defined, 103-04, 164 flow, of a project. feed budget and, 183 of economic values, 40 herd projection and, 116-17, 174-75 farm budget, 287-89 labor use analysis and, 105 farm budget and declining debt ser- stable herd determination and, 178 vice and, 138 Annual equivalent. A STREAM of equal government agencies and, 289-91 amounts paid or received annually for incremental net benefit and, 296 a period such that by DISCOUNTING at labor payments and, 294, 296 an appropriate INTEREST rate it will manager remuneration and, 294-95 have a specified PRESENT WORTH. De- national income measures and, 292, termined by multiplying an initial 293, 294, 296 value by the CAPITAL RECOVERY FACTOR processing industries and, 289 for the appropriate interest rate and unit activity budget calculations period. To "annualize" is to find the and, 146 annual equivalent of a value. value added and, 293, 294 Annual financial equivalent (cost recov- Agricultural Credit Project (Honduras), ery index), 227 150-51, 152 Annualize. See ANNUAL EQUIVALENT Agricultural Minimum Package (Ethi- Annuity. An amount paid or received opia), foreign exchange premium ex- annually or at other regular intervals ample and, 249-50 for a stated period of time. See EQUAL Agricultural projects. See Projects INSTALLMENTS CGLOSSARY-IN) FX 459 Appraisal. Analysis of a proposed INVEST- tion by the number of years over MENT to determine its merit and which the value will be realized and acceptability in accordance with then dividing the result by the undis- established decision criteria. counted outlay for the initial Appraisal of Productive Projects in Agri- INVESTMENT. culture: Economic Analysis and Rate Average income on book value of invest- of'Return (Commission of the Euro- ment, 303-04. An undiscounted pean Communities 1980), 438 MEASURE OF PROJECT WORTH. Average Appraisal of projects, 24 INCOME divided by the book value of analysis accuracy and, 27 the assets (that is, the value of the Arithmetic mean. The total value of the ASSETS after subtracting entries in a series divided by the num- DEPRECIATION), stated as a percentage. ber of entries. The average. Asia, poor irrigation project planning example in, 37 Bacha, Edmar, 248 Aspects of project preparation and Balance of payments, 217 analysis. See PROJECT ANALYSIS; Balance sheet, 190. For a particular time, PROJECT PREPARATION; specific aspects usually the end ofan ACCOUNTING of projects, e.g., economic, manage- PERIOD, a tabulation of the ASSETS of rial, etc. an enterprise in one column (on the Assets. Property or claim owned by an in- left in American usage, on the right dividual or an enterprise. "Current" In British usage) and its liabilities assets consist of cash and items ex- and owners' EQUITY on the opposite pected to be converted into cash with- side. These two columns are always in a reasonably short period, usually equal, and therefore the accounting one year. "Fixed" assets are durable equation (assets = liabilities + own- items of relatively long life that are ers' equity) must always hold true. used by the enterprise for production preparation of, 192-95 of goods and services. On a BALANCE Baldwin, George B., 292 SHEET, "other" assets include assets Barnum, Howard N., 259 such as patents and trademarks, Baseline cost. See COST which have no physical existence but B/C ratio. See BENEFIT-COST RATIO are ofvalue to the enterprise; invest- Benefit. In PROJECT ANALYSIS, any good or ments in other companies or in secur- service produced by a PROJECT that ities; deferred expenses such as start- furthers the objective of the entity up expenses; and miscellaneous other from whose standpoint the analysis is assets peculiar to particular types of being undertaken. In the analytical enterprises. system outlined tn this book, benefits balance sheet preparation and, 192-95 are goods and services that increase current ratios and current, 207 the INCOME of farmers or firms, or in- incremental net benefit before financ- crease the NATIONAL INCOME of the ing calculation and, 212 society. When it is possible to value return on (income ratio), 207 benefits, the increase is valued either salvage value of capital, 118 at MARKET PRICES in FINANCIAL sources-and-uses-of-funds statement ANALYSIS or at ECONOMIC VALUES in and, 198, 199, 201 ECONOMIC analysis. INTANGIBLE ben- Associated cost. The value of goods and efits cannot be incorporated in the services over and above those goods benefit-cost framework, even though and services included in the project they are accepted as valuable, and so COSTS incurred to make the immediate must be dealt with subjectively or in- products or services of the PROJECT directly, often through a COST available for use or sale. Used in U.S. EFFECTIVENESS ANALYSIS. See Benefits government practice for computing Benefit-cost ratio (B/C ratio), 299, 342. A the BENEFIT-COST RATIO at MARKET discounted MEASURE OF PROJECT PRICES. WORTH. The PRESENT WORTH of the Average annual proceeds per unit BENEFIT STREAM divided by the pres- of outlay, 303. An undiscounted MEA- ent worth of the COST STREAM. For a SURE OF PROJECT WORTH. Calculated formal mathematical definition, see by dividing the total net (undis- the appendix to chapter 9. Often counted) value of incremental produc- abbreviated "B/c ratio." Also fre- 460 GLOSSARY-INDEX Benefit-cost ratio (continued) project. Commonly it takes the form quently called the "cost-benefit ratio " of a BETTERMENT LEVY assessed When the benefit-cost ratio is used, against the land benefited; it may be the selection criterion is to accept all varied according to the different crops INDEPENDENT projects with a ben- grown. efit-cost ratio of I or greater when aggregation and, 290 discounted at a suitable DISCOUNT cost recovery example and, 224, RATE, most Often the OPPORTUNITY 225-26 COST OF CAPITAL. May give incorrect rent recovery and, 232 ranking among independent projects, Betterment levy. A TAX that is assessed and cannot be used for choosing on project beneficiaries and is in- among MUTUALLY EXCLUSIVE alterna- tended to recover from them some tives. part of the BENEFIT generated by the analysis of, 343-46 PROJECT and realized by them. Often comparisons and ranking of, 358-61 assessed on the basis of land areas. computation of discounted measures Bierman, Harold, Jr., 300 and, 358 Bigg, W. W., 190 depreciaton and, 351, 355 Book value. See AVERAGE INCOME ON BOOK mutually exclusive projects and, 373 VALUE OF INVESTMENT net present worth and, 327 Border price. The unit price of a TRADED project selection and, 346, 350, 351 good at a country's border. For ex- Benefits. See also Incremental net ben- ports, the F O.B. price; for imports, the efit; Net benefit entries c.I.F. price. See PRICE; compare with cost recovery example and, 224 FARM-GATE PRICE defined, 43-47 foreign exchange premium and, 248 delay (switching value method), 373 joint cost allocation and, 233 direct transfer payments and, 50-52 price distortions in traded items and, disadvantaged farmers and, 132 251, 253 economic values determination and Boundary. See PROJECT BOUNDARY intangible, 279-84 Brazil, 10 electricity and, 391 Alto Bene Amazon Basin Project future prices and inflation and, 76 in, 257 housing and, 59 Alto Turi Land Settlement Project in, intangible, 61-62, 279-84 49-50 location of sale change and, 57-58 Ceara Rural Development Project loss avoidance and, 58-59 in, 150 mechanization and, 58 Breeding cow negative, 318 animal units and, 174-75 processing and grading and, 58 computational conventions and, 165 production increases and, 56-57 culling rate and, 167 project preparation and, 427-28 defined, 164 quality improvement and, 57 herd growth and, 179, 180, 181 separable costs-remaining benefits ratio of bulls to, 167-74 method and, 234-40 stable herd determination and, 175, time of sale change and, 57 176, 178, 179 transport and, 58, 59 Brown, Maxwell L., 90, 91, 141 with and without comparisons and, Bruno ratio, 398. See also DOMESTIC 47-50 RESOURCE COST Benefit stream. A series of benefit values Budgets. See also FARM BUDGET; Feed extending over a period of time, gener- budget; UNIT ACTIVITY BUDGET ally several years. See BENEFIT; in agricultural projects, 72 STREAM cost recovery and, 216 Benefit tax, 216. A TAX levied in addition financial aspects of projects and, 17 to charges paid directly by the ben- steps in project analysis and, 40 eficiary to recover COST and a share of Building costs (balance sheet), 193 incremental BENEFIT. In an irrigation Bulls PROJECT, a tax levied on project bene- computational conventions and, 165 ficiaries that is intended to recover culling rate and, 166-67 part or all of project cost and part of defined, 164 the ECONOMIC RENT generated by the herd growth and, 179, 180, 181 GLOSSARY-INDEX 461 ratio of breeding females to, 167-74 ment factor." The expression [i(1 + stable herd determination and, i)n+ [(1 + 0n - 1] where i = the 176, 178 rate of interest and n = the number of years. The reciprocal of the PRESENT WORTH of an ANNUITY factor. Calculators Generally obtained from a set of com- herd projection calculations and, 183 pounding and discounting tables. project analysis and, 401-08 This factor permits calculating the Calf EQUAL INSTALLMENTS necessary to re- computational convention and, 165 pay (amortize) a loan over a given defined, 164 period at a stated interest rate. The herd growth and, 179, 181 total payment is a varying combina- mortality, 116, 164, 165, 166, 176 tion of both interest and repayment stable herd determination and, 176, (amortization) of PRINCIPAL. See 177, 178, 179 appendix B Calving rates, 165, 166 Caqueta Rural Development Project (Co- Canal Lining Project (Pakistan), 48-49 lombia), 257-58 Capital. In an economic sense, goods cre- Carrying capacity. The amount of feed ated by the process of INVESTMENT available from a pasture area, gener- that are capable of producing eco- ally stated in ANIMAL UNITS. nomic wealth. It is thus, generally, animal units and, 116-17, 174-75 REAL capital. Capital in this sense is feed budget and, 183 one of the three classic FACTORS OF pasture and, 164, 174, 175 PRODUCTION (along with labor and stable herd determination and, 175, land, whose productivity capital en- 176, 178, 179 hances). In an accounting sense, the Cash stock of funds and other ASSETS as current assets, 193 owned by an individual or an enter- economic values determination prise. The total funds provided by and, 247 owners or shareholders plus retained expenditures for operations, 202 earnings (that is, EQUITY). The excess rate of return and, 210 of assets over LIABILITIES. See also In- rent recovery and, 229 cremental working capital; WORKING sources-and-uses-of-funds statement CAPITAL and, 201, 202 balance sheet and share, 195 Cash accounting, 191 economic analysis and, 19-20 Cash basis accounting. A method of re- farmer's own, 129, 140 cording accounting transactions only farm investment analysis and, 98-99 when cash receipts or expenditures incremental net benefit and borrowed, occur. Distinguished from ACCRUAL 317, 318 ACCOUNTING. initial expenditure of, 217 Cashew Project (India), 142-46, rent recovery and, 231 157-58, 406 Capital cost to irrigation (separable Cash flow. See also NET BENEFIT costs-remaining benefits discounting process and analysis method), 240 of, 95 Capitalize. In credit transactions, to add government, 217-20 INTEREST due during the GRACE PERIOD incremental net benefit flow definition to the PRINCIPAL of a loan so that the and, 209-10 borrower need not pay any interest noncash elements and, 89 during the grace period. When repay- Cash operating expenses ment begins, the amount borrowed income statement and, 195-96 plus the interest capitalized becomes incremental net benefit before financ- the principal that must be repaid. ing calculation and, 211 Capital recovery (calculator example), Cash position, farmer's needs and, 134 406-07 Cash (surplus or deficit), 202 Capital recovery factor, 236. The annual government cash flow and, 220 payment that will repay a loan of I Ceara Rural Development Project (Bra- currency unit in x years with com- zil), 150 pound INTEREST on the unpaid ba- C.i.f. (cost, insurance, and freight). The lance. Also called the "partial pay- landed COST of an import on the dock 462 (, L01S ARY-IN)EX Ci.f. (continued) Compounding and Discounting Tables for or other entry point in the receiving Project Evaluation (Gittinger 1973) country. Includes cost of interna- compounding interest and, 306-07 tional freight and insurance and often discounting present worth and, 308, includes cost of unloading onto the 311, 312 dock. Excludes any charges after the equal installment repayments and, import touches the dock and excludes 153, 156 all domestic TARIFFS and other TAXES internal rate of return determination or fees. Compare with F.O.B. and, 335 C.i.f. prices use of calculators and, 405 export and import parity prices and, Compounding factor for 1. What an ini- 78-79, 80 tial amount of I becomes when grow- export and import parity values and, ing at compound INTEREST. Also 269, 270, 271 called the "compound interest factor" indirectly traded items and, 266 and the "amount of 1." The expres- price distortions in traded items sion (1 + i)n where i = the interest and, 253 rate and n = the number of years. Civil engineering works, contingency al- Usually obtained from a set of com- lowances and, 395 pounding and discounting tables. See Climate appendix B poor project analysis and, 36 Compounding factor for I per annum. project preparation and, 415 Growth of equal year-end deposits of Coefficient of variation. A measure of the 1, all growing at compound INTEREST. dispersion of a frequency distribution. Also called the "compound interest Calculated by dividing the STANDARD factor for I per annum" and the deviation by the ARITHMETIC MEAN Tamount of I per annum." The ex- and multiplying the result by 100. pression [(1 + i)n - 1] - i where i Collateral. Property pledged by a borrower = the rate of interest and n = the to protect the interests of the lender. number of years. The reciprocal of the Colombia, Caqueta Rural Development SINKING FUND FACTOR. Generally Project in, 257-58 obtained from a set of compounding Command area. The area that can be irri- and discounting tables. This factor gated by a particular group of irriga- permits calculating the value to tion works. which a constant amount deposited Commercial aspects of projects, 16 at the end of each year will grow by Commitment fee. A fee paid by a borrow- the end of a stated period at a stated er to a lender in the period between interest rate. See appendix B approval of a loan and disbursement Compound interest. See INTEREST of the loan. Intended to reimburse the Compound interest factor. See coM- lender for the cosT associated iwith POUNDING FACTOR FOR I and ap- meeting a disbursement request on pendix B demand. Usually stated as a percen- Compound interest factor for I per an- tage of the loan amount approved and num. See COMPOUNDING FACTOR FOR 1 much less than the INTEREST rate PER ANNUM charged for the loan commencing Computers with disbursement. herd projection calculations and, 183 Committees (coordinating), 33 project analysis and, 408 Compounding. The process of finding the Connor, Larry J., 90 future value in some future year of a Constant. Refers to a value, most often a present amount growing at compound PRICE, from which the overall effect of INTEREST. The future value is deter- a general price inflation has been re- mined by multiplying the present moved. A "constant price" is a price amount by the expression (1 + i)" that has been deflated to REAL terms where i = the interest rate and n = by an appropriate "price index" (a the year. This expression is usually series that records changes in a group obtained in the form of the of prices relative to a given, or base, COMPOUNDING FACTOR FOR I from a set period-see index number). May refer of compounding and discounting either to a MARKET PRICE or a SHADOW tables. PRICE. Compare with CURRENT; see GLOSSA RY-IN)EX 463 Constant prices; Constant terms; Conversion factor approach REAL BURDEN OF DEBT SERVICE foreign exchange premium and, Constant prices 248-49, 254 declining real burden and, 158 import parity value and, 270 farm investment analysis and, 89 indirectly traded items and, 266, predicting future prices and inflation 267-69 and, 76-77 Cooperatives Constant terms project preparation and, 424 foreign exchange flow and, 221 sharing bulls and, 174 government cash flow projections Coordinating committees, 33 and, 217 Cost. In PROJECT ANALYSIS, any good or Construction service a PROJECT uses that reduces balance sheet calculation and, 195 progress toward the objective of the farm investment and, 121 entity from whose standpoint the residual value and, 119 analysis is undertaken. In the analy- Construction costs, 53, 235, 239 tical system outlined in this book, sensitivity analysis and, 365 costs are goods and services that re- Consultants duce the INCOME of farmers or firms, administrative problems and, 33 or reduce the NATIONAL INCOME of the farm investment analysis and, 92 society. When it is possible to value a financial statements and, 192 cost, it is valued at MARKET PRICES in project preparation assistance and, FINANCIAL ANALYSIS Or at an ECONOMIC 441-43 value in economic analysis. Consumption value. See VALUE IN USE INTANGIBLE costs cannot be incorpo- Contingency allowance. An amount in- rated in the benefit cost framework, cluded in a project account to allow even though they are accepted as im- for adverse conditions that will add to portant, and so must be dealt with baseline COSTS. Physical contingencies subjectively, or indirectly, often allow for physical events such as through a COST EFFECTIVENESS ANALY- adverse weather during construction; sis. "Baseline costs" are costs at they are included in both the some period at or before the begin- FINANCIAL and the ECONOMIC ANALYSIS. ning of a project and become the Price contingencies allow for general basis for later evaluation of the effects inflation; in PROJECT ANALYSIS they of the project. See Costs, Cost entries are omitted from both the financial Cost allocation (joint) and the economic analysis when the general principle of, 233-34 analysis is done in CONSTANT prices. separable costs-remaining benefits agricultural credit projects and, 394 method and, 234-40 costs and, 393, 394, 395 Cost-benefit ratio. See BENEFIT-COST RATIO inflation and, 393-94, 395 Cost effectiveness, 280 physical, 53-54, 359 Cost effectiveness analysis. An APPRAISAL price, 53-54, 393-94, 395 and program-monitoring technique price change and, 393-94, 395 used primarily in social PROGRAMS project analysis and, 394-95 and PROJECTS in the health, popula- project costs and, 53-54 tion, nutrition, and related sectors in project preparation and, 421 which BENEFITS cannot be reasonably Conventions, accounting. See Accounting measured in MONEY TERMS. It may convention (time-adjusted) also be used to choose among tech- Conversion factor. A number, usually less nologies considered for use within a than 1, that can be multiplied by the project. Cost effectiveness analysis is domestic MARKET PRICE, OPPORTUNITY used in two forms: (1) the "constant COST, or VALUE in use of a NONTRADED effects" method, which uses least-cost item to convert it to an equivalent analysis to determine the least-cost BORDER PRICE that reflects the effect of alternative for meeting a stated level trade DISTORTIONS on domestic prices of benefits, including INTANGIBLE ben- of that good or service. A standard efits; and (2) the "constant cost" conversion factor is the reciprocal of method, which calculates the cost per 1 plus the FOREIGN EXCHANGE unit of benefit, or the "cost effective- PREMIUM stated in decimal form. ness ratio," and requires that means 464 GLOSSARY-INDEX Cost effectiveness analysis (continued) project COST recovered from project exist for quantifying benefits (but not beneficiaries. In an irrigation necessarily for attaching a monetary PROJECT, the ratio of the PRESENT price or economic value to the ben- WORTH of incremental water charges efits). Quantitative measures such as plus the present worth of incremental "couple-years-of-protection" (cYP) are BENEFIT TAXES divided by the present used in population projects, for exam- worth of incremental public sector ple, to quantify project OUTPUTS outlays and stated in percentage rather than to place monetary values terms. Calculated at CONSTANT, on the outputs. The preferred prolect MARKET PRICES. alternative usually either minimizes Costs the discounted PRESENT WORTH of cost balance sheet preparation and, 193 per unit or maximizes the discounted consultant use and overruns of, present worth of units of output per 442-43 unit ofcurrency. The DISCOUNTING is contingency allowances and, 53-54, normally done at the OPPORTUNITY 393-95 COST OF CAPITAL or the CUT-OFF RATE. cost recovery example and, 224, If cost effectiveness analysts is used 226-28 within a project to choose among debt service and, 54-55 alternative technologies to determine defined, 43-47 the most cost effective means to pro- delays and increases in, 28-29 duce intermediate project outputs, it direct transfer payments and, 50-52 is most often done in the form of the domestic resource, 398-400 constant effects method and called economic values determination and "least-cost analysts " The preferred intangible, 279-84 alternative is the one that has the future prices and inflation and, 76 lowest present worth, and the prefer- government receipts and expenditures ence may change when different and, 215, 216, 217 INTEREST rates are used to determine intangible, 61-62, 279-84 the present worth. The interest rate at labor, 53 which the present worths of two dif- land, 53 ferent alternatives are the same (ond, physical goods, 52-53 hence, the analyst is indifferent be- poor project analysis and estimating, tween alternatives on cost grounds) is 35-36 known as the CROSSOVER DISCOUNT project preparation and, 421-22 RATE. It is Impossible to obtain a replacement, 395-97 MEASURE OF PROJECT WORTH from cost secondary, 59-61 effectiveness analysis since the analy- sensitivity analysis and estimating, sts is done without reference to the 364-65 value to users of the project output separable costs-remaining benefits Cost estimates method and, 234-40 project preparation and, 420-21 sunk, 55 sensitivity analysis and, 364-65 taxes and, 54 Cost, insurance, and freight. See c.i.F., with and without comparisons and, C.i.f. prices 47-50 Cost overruns, 27 Costs and benefits analysis, 19 consultants and, 443 Cost stream. A series of COST values ex- project delays and, 29 tending over a period of time, gener- sensitivity analysis and, 364, 365-71 ally several years. See cosT; STREAM Cost recovery Cotton Processing and Marketing Project benefit taxes and water charges and, (Kenya), 371-73 225-26 Credit See also DEBT SERVICE; Loans government receipts and expenditures computing debt service and, 147 and, 215-17 contingency allowances and, 394 measuring, 226-28 direct transfer payments and, 52 measuring rent recovery and, 228-32 discounting assumptions and, 99 objectives of, 223-24 financial aspects of projects and, 17 overview of policy for, 222-23 financial price adjustments (transfer project preparation and, 426-27 payments) and, 251 Cost recovery index. The proportion of poor project analysis and, 31, 32 GLOSSARY-INDEX 465 project delays and projects for, 29 operating expenditure and, 98, 123 project preparation and, 419, 423 projected farm production and, simple interest calculations and, 112, 113 147-50 response to nitrogen fertilizer example sources-and-uses-of-funds statement (Philippines) and, 65-69 and, 202 separable costs-remaining benefits unit activity budget and, 146 method and, 234 Creditworthiness. The ability of an indi- unit activity budgets and, 141, 142 vidual, firm, or nation to meet its Crossover discount rate, 383-88. The DEBT SERVICE obligations. For a firm, DISCOUNT RATE that equalizes the a judgment about creditworthiness is PRESENT WORTHS of the COST STREAMS often formed on the basis of one or of two alternatives producing the another FINANCIAL RATIO. same result. Usually used to choose Creditworthiness ratio, 191, 207-09 between two technological alterna- Critical path diagram. A diagram that tives or alternative project designs plots the sequence of activities for having different time streams. The project planning and scheduling, preferred alternative is the one with shows which activities must be com- the lowest present worth. At some dis- pleted before others can commence, count rate, alternatives having differ- and indicates which activities cannot ent time streams may have equal be delayed without delaying the whole present worths; at a higher discount PROJECT. Variously referred to as rate, a different alternative is preferred "critical path method" (cpM), "pro- from that below the rate. Also called gram evaluation and review tech- the "equalizing discount rate."-May nique" (PERT), or "network analysis." be determined graphically by plotting See Mulvaney (1969). the present worth of the two alterna- Cropping intensity. Total cultivated area tives at different discount rates or on a farm divided by total cropland. may be computed by finding the When there is MULTIPLE CROPPING, the INTERNAL RATE OF RETURN to the dif- cropping intensity may be greater ferences year by year between the than 1. Often reported as a percen- cash flows of the alternative with the tage. Thus, a farm where 7 hectares higher undiscounted COST less the are cultivated as a result of multiple alternative with the lower undis- cropping, but where there are only 5 counted cost. hectares of total cropland, has a crop- Cull. In livestock husbandry, to remove as ping intensity of 1.4 (7 - 5 = 1.4), a result of failure to meet a standard. or 140 percent. Culled animals are animals removed Cropping pattern. The area devoted to, from a herd because they do not meet and the sequence of, crops produced performance standards. A culling rate by a farmer or in a region. is the proportion of animals of a Cropping patterns class removed for failure to meet per- climate and, 415 formance standards; it is generally computer use and, 408 stated as a percentage. family labor and, 139 Culled animals farm investment analysis and, 90, 91, defined, 164 92,93 rates of, 166-67 land use analysis and, 100-01 project preparation and, 415-16, 418 unit activity budgets and, 142 Cumulative surplus (deficit). In a govern- with and without project and, 138 ment cash flow account for a Crops PROJECT, the difference between cash budgets (aggregation) and, INFLOW and cash OUTFLOW from the 287-89, 291 beginning of the project through a climate and poor project estimates given year. Compare with CURRENT for, 36 SURPLUS (DEFICIT) inappropriate technology and, 30 Currency incremental working capital for, 127 economic values determination and labor use analysis and, 102-03, domestic, 244 105, 111 foreign exchange premium and land use analysis and, 100-01 domestic, 247 466 GLOSSARY-INDEX Current. Refers to a value, most often a 60.40. A FINANCIAL RATIO used to de- PRICE, that includes the eftects ofgen- termtne the degree of LEVERAGE and to eral price INFLATION. A past value or help form judgments about risk and price as actually obsered; a future CREDITWORTHINESS. value or price as expected to occur. Debt service. A payment made by a bor- Compare with CONSTANT. In economic rower to a lender. May include one or literature, a constant price is usually all of: (1) payment of INTEREST; (2) re- specified if it is intended; otherwise, payment of PRINCIPAL; and (3) loan one infers that a current price is m- COMMITMENT FEE. See alSO EQUAL tended. See Current costs; Current INSTALLMENTS; Credit; Loans prices; CURRENT RATIO; Current computation of, 147-62 terms declining real burden assumption and, Current costs, project preparation 158-62 and, 422 direct transfer payments and, 50 Current prices equal installments calculations and, farm investment analysis and, 89 153-58 measures of project worth and, farm budget and, 129, 133-38 400-01 financial planning and, 87 predicting future prices and inflation foreign exchange flow and, 222 and, 76-77 government cash flow and, 219, 220 Current ratio, 207-08. Current ASSETS di- project costs and, 54-55 vided by curent LIABILITIES. A FINAN- repayment of equal amounts of princi- CIAL RATIO used to judge LIQUIDITY or pal and, 150-53 CREDITWORTHINESS. simple interest calculations and, Current surplus (deficit). In a govern- 147-50 ment cash flow for a PROJECT, the dif- sources-and-uses-of-funds statement ference between cash INFLOW and and, 202 cash OUTFLOW for any gwven year. unit activity budget calculations Compare with CUMULATIVE SURPLUS and, 146 (DEFICIT) Debt service coverage ratio, 209 Current terms Debt service ratio. (Net INCOME + foreign exchange flow and, 221 DEPRECIATION + INTEREST paid) + government cash flow projections and, (interest paid + repayment of LONG- 217 TERM loans). A FINANCIAL RATIO used Cut-off rate, 314, 381. The rate below to judge CREDITWORTHINESS. which a PROJECT is considered un- Decisionmaking process, 94 acceptable. Often taken to be the sensitivity analysis and, 369 OPPORTUNITY COST OF CAPITAL. The cut- Decision tree (economic values deter- off rate would be the minimum mination), 282-83, 284. The diagram acceptable INTERNAL RATE OF RETURN used in an analytical technique by for a project or the DISCOUNT RATE which a decision is reached through used to calculate the NET PRESENT a sequence of choices between WORTH, the NET BENEFIT-INVESTMENT alternatives. So called because the di- RATIO, or the BENEFIT-COST RATIO. agram resembles a tree lying on its Cycle of projects, 21-26 side. Declining real burden of debt service. See REAL BURDEN OF DEBT SERVICE Decomposition. In ECONOMIC ANALYSIS, Data the process of separating out the con- discount measure computation and, stituent elements of a value; for exam- 356-57 ple, determining the value of the project format and, 8 TRADED and NONTRADED proportions of Debt-equity ratio, 208. [LONG-TERM LIA- an INDIRECTLY TRADED Item. BILITIES + (long-term liabilities + Deflation. The act of adjusting CURRENT EQUITY)] - [Equity + (long-term lia- prices to CONSTANT prices. The artth- bilities + equity)]. Usually stated as metic (division) is the same as for the first bracketed part of the equation DISCOUNTING. compared with the second bracketed Delays (project) part of the equation, with both parts implementation and, 28-29, 36 multiplied by 100, in a ratio such as procurement problems and, 33 CLOSSARY-INDEX 467 sensitivity analysis and, 364, 369-71 up toward FULL DEVELOPMENT. In Demand, market price as estimate of agricultural projects, often three to economic value and, 255 five years, but mayv be longer if the Depreciation. The anticipated reduction project involves cattle herds, tree in the value of an ASSET over time crops, or other INVESTMENTS with long that is brought about through phys- gestation. rcal use or obsolescence. In account- Direct tax. See TAX ing, depreciation refers to the process Direct transfer payment. See TRANSFER of allocating a portion of the original PAYMENT COST of a fixed asset to each Disbursement period (project prepara- ACCOUNTING PERIOD SO that the value tion), 419-20 is gradually used up ("written off") Discounted cash flow analysis. Analysis during the course of the asset's esti- based on the net incremental COSTS mated "useful life." Allowance may and BENEFITS (see NET BENEFIT) that be made for the ultimate estimated re- form the incremental cash flow. It sale value of the fixed asset (its yields a discounted MEASURE OF RESIDUAL VALUE) to remain at the end PROJECT WORTH such as the NET of its useful life to the enterprise. PRESENT WORTH, INTERNAL RATE OF There are two principal types of de- RETURN, or NET BENEFIT-INVESTMENT precation methods: "straight-line" RATIO. depreciation, which allocates the cost Discounted measure of project worth. of a fixed asset in equal amounts for See MEASURE OF PROJECT WORTH each accounting period, and "acceler- Discounted measures. See also BENEFIT- ated" depreciation, which allocates a COST RATIO (B/C RATIO); INTERNAL RATE larger proportion of the original cost OF RETURN (IRR); MEASURES OF to earlier accounting periods and a PROJECT WORTH; NET BENEFIT- smaller proportion to later periods. In INVESTMENT RATIO (N/K RATIO); NET DISCOUNTED CASH FLOW ANALYSIS depre- PRESENT WORTH ciation is not treated as a cost. In- application of, 350-51 stead, the cost ofan asset is shown in choice of, 313-15 the year it is incurred, and the comparisons of, 358-61 BENEFITS are shown in the year they computation of, 356-58 are realized. Since this is done over mathematical formula for, 361 the life of the PROJECT, no deprecia- practical considerations concerning, tion allowance is needed to show the 299-300, 308-09, 313 proportion of the value of the asset project life and, 355-56, 357 used in any given year. time value of money and, 313-15 accumulated allowances (balance Discount factor. How much I at a future sheet) for, 195 date is worth today. Also called the discounted measures and, 351-55 "present worth factor" and the "pre- farm income analysis and, 89 sent worth of 1." The expression I financial rate of return calculations (1 + i)" where i = the rate of and, 210 INTEREST (DISCOUNT RATE) and n = incremental net benefit derivation the number of years. The reciprocal of and, 316-17 the COMPOUNDING FACTOR FOR 1. mutually exclusive projects and, 382 Generally obtained from a set of com- operating income before (sources-and- pounding and discounting tables. uses-of-funds statement), 198 This factor permits determining the rent recovery and, 229 value today of an amount received or "straight-line," 196 paid out in the future. The process of Developing countries finding the PRESENT WORTH ofsome planning economic growth for, 6-7 future value is generally referred to as UNDP assistance and, 438-39 DISCOUNTING. Since the discount fac- Development tor is the reciprocal of the compound- project preparation and, 413 ing factor for 1, it is common to hear projects as initiative for, 11 expressions such as "discounted at rural projects and, 15 an interest rate of 14 percent." See Development period. With respect to a appendix B PROJECT, the period after the INVEST- calculator example of, 406 MENT PERIOD when production builds project life and, 356 468 GLOSSARY-INDEX Discount factor for a stream of income. earn a unit of FOREIGN EXCHANGE See PRESENT WORTH OF AN ANNUITY through a proposed PROJECT. In FACTOR DISCOUNTED CASH FLOW ANALYSIS, the Discounting. The process of finding the PRESENT WORTH of the domestic cur- PRESENT WORTH Of a future amount. rency cost Of realzing a foreign ex- The present worth is determined by change saving divided by the present multiplying the future amount by the worth of the net foreign exchange say- expression I -- (1 + i)n where i = ing A project is accepted if the the DISCOUNT RATE (INTEREST rate) domestic resource cost is less than and n = the year. Generally this ex- the OFFICIAL EXCHANGE RATE in pression is obtained in the form of a FINANCIAL ANALYSIS or less than the DISCOUNT FACTOR from a set of com- SHADOW EXCHANGE RATE (or the rectp- pounding and discounting tables. The rocal of the STANDARD CONVERSION concept underlying discounting is FACTOR) in ECONOMIC ANALYSIS. Also sometimes referred to as the TIME called the "Bruno ratio." Initially VALUE OF MONEY. formulated as an undiscounted mea- aggregation and, 291 sure based on a single year. investment at beginning of the year Domestic value added. The value added and, 99 to a product by local or domestic project life and, 355-56, 357 activities. In an INDIRECTLY TRADED rent recovery and, 232 item, domestic value added is the time value of money dimension of, total value of the product less the 304-15 BORDER PRICE of imported compo- used in cash flow analysis, 95 nents. See VALUE ADDED Discounting tables, 431-35. See also Doukkala II Irrigation Project (Mo- Compounding and Discounting rocco), 150 Tables for Project Evaluation (Gittin- Drought Prone Areas Project (India), 289 ger 1973) Duties Discount rate, 350, 386. The INTEREST income statement and, 197 rate used to determine the PRESENT incremental net benefit before financ- WORTH of a future value by ing calculation and, 212 DISCOUNTING. Duty. A TAX levied on an import. Distortion. A state in which the MARKET PRICE of an item differs from the PRICE it would bring in the absence of Early Crop Maize Project (Nigeria), government restrictions. In PROJECT 80-82, 83, 271, 276-77 ANALYSIS, the principal distortion con- Earnings (retained), 195 sidered is the trade TARIFF, which per- East African producer price example, 35 mits domestic market prices to exceed Economic account, valuing labor and, BORDER PRICES (allowing for domestic 258, 259 transfer costs). Economic analysis. Analysis done using Distribution weight. The relative impor- ECONOMIC VALUES. In general, econo- tance attached to various INCOME mic analysis Omits TRANSFER groups among the beneficiaries of a PAYMENTS (including credit transac- PROJECT. Income received by one or tions) and values all items at their another group is adjusted by the VALUE IN USE or their OPPORTUNITY weight so that the final MEASURE OF COST to the society (often a BORDER PROJECT WORTH will favor those PRICE for TRADED items) groups accorded greater importance. cut-off rate and, 314 See Squire and van der Tak (1975). debt service and, 55 Compare with SAVINGS WEIGHT discount factors and, 355-56, 357 Diverted exports A project INPUT that discount measure selection and, 359 would have been exported had there economic values and, 244, 245, 246 been no PROJECT. See TRADED financial analysis as complement Dividend. INCOME distributed to share- to, 18 holders ofan enterprise. financial prices and, 243 Djatiluhur Irrigation Project. See Jatilu- foreign exchange premium and, 248 hur Irrigation Project (Indonesia) incremental net benefit derivation Domestic prices, 425-26 and, 317-18 Domestic resource cost, 398-400. The price systems used in, 69 COST in domestic currency required to project analysis accuracy and, 27-28 GLOSSARY-INDEX 469 project aspects and, 19-21 export and import parity values and, project objectives and, 46 252, 269-71 secondary costs and benefits and, financial price adjustment and, 59-60 251-71 sensitivity analysis and, 363 foreign exchange premium and, taxes and, 54 247-50 Economic efficiency, cost recovery and, indirectly traded items and, 265-69 223-24 intangible costs and benefits and, Economic growth 279-84 economic analysis and, 21 nontraded items and, 253-65 planning, 6-7 overview of, 243-47 Economic life. The period during which a traded goods and, 251-53 fixed ASSET is capable of yielding ser- trade policy changes and, 271-78 vices to its owner. Distinguished from transfer payments and, 251 "physical life," a period often longer, Ecuador, Livestock Development Project during which a fixed asset can con- in, 57 tinue to function notwithstanding its Educational benefits, 280 acquired obsolescence, inefficient op- Efficiency (economic), cost recovery and, eration, high cost of maintenance, or 223-24 obsolete product. Efficiency price. An ECONOMIC VALUE used Economic rate of return. The INTERNAL in ECONOMIC ANALYSIS that reflects the RATE OF RETURN calculated using ECO- OPPORTUNITY COST or VALUE IN USE Of NOMIC VALUES. The internal rate of re- a good or service used or produced by turn used in ECONOMIC ANALYSIS. See a PROJECT. It may be a MARKET PRICE INTERNAL RATE OF RETURN. See also or SHADOW PRICE. Efficiency prices are RATE OF RETURN the values used in economic analysis aggregation and, 291 when the objective is to maximize discount measures computation and, NATIONAL INCOME (the objective 357-58 assumed in this book). Hence, eco- internal rate of return and, 331 nomic analysis done using efficiency mutually exclusive projects and, prices is sometimes called "efficiency 379-81, 383 analysis." When the objective of a project analysis accuracy and, 27-28 project is something other than sensitivity analysis and, 364 national income (as might be the case Economic rent, 231-32. The return for in analyses that formally incorporate the use of a FACTOR OF PRODUCTION in INCOME DISTRIBUTION or savings excess of the minimum required to objectives), the efficiency price may be bring forth the service of the factor. adjusted by an appropriate DISTRIBU- The surplus remaining to a project TION WEIGHT. beneficiary after he receives the re- Efficiency prices wards necessary to attract physical cost recovery and, 224 INPUTS, labor, entrepreneurship, and cut-off rate and, 314 the willingness to bear risk. economic values determination and, Economic value. The amount by which 244, 245, 246 production of a project OUTPUT or use foreign exchange premium and, 249 of a project INPUT changes NATIONAL incremental net benefit and, 129 INCOME (or other national objective in Efficiency ratio, 191, 203-06 PROJECT ANALYSIS). May be a MARKET Egypt PRICE or may be an estimate of VALUE Lower Egyptian Drainage Project IN USE or OPPORTUNITY COST that dif- in, 59 fers from the market price, in which valuing labor and, 262 case it is a SHADOW PRICE. In general Electricity, 234 in this book, the term "value" is used indirectly traded items calculations to distinguish amounts discussed in and, 267 connection with ECONOMIC ANALYSIS least-cost combination method and, from amounts discussed in connec- 280-81, 281-84 tion with FINANCIAL ANALYSIS (these project purpose and choice and, latter amounts are referred to as 391-93 FINANCIAL Or MARKET PRICES). Employment Economic values project preparation and, 427 decision tree for, 282-83, 284 valuing labor and, 258, 261 470 GLOSSARY-INDEX Energy, predicting future prices and, 75 then be taken to be equal to the vari- Environmental impact, 15-16 able cost necessary for the produc- project preparation and, 422 tion. More common in industrial Equal installments. The amount of DEBT than in agricultural projects. SERVICE when a loan is repaid in a financial price adjustment (nontraded series of payments of the same total items) and, 263 amount but of varying proportions of secondary costs and benefits and, 61 PRINCIPAL and INTEREST. The equal in- Exchange rate, 400 stallment is computed by multiplying economic values determination the principal by the CAPITAL RECOVERY and, 244 FACTOR. Also called a "level payment" foreign exchange premium and or an "equated annuity." shadow, 248-49 Equalizing discount rate. See CROSSOVER indirectly traded items and shadow, DISCOUNT RATE 266, 267, 269 Equated annuity. See EQUAL Expansion (project facilities), 191 INSTALLMENTS Expatriate. A national of one country Equipment who is living in another country balance sheet preparation and, 195 Expenditures, separable costs-remain- contingency allowances and, 395 ing benefits method, 238. See also cost estimates and, 365 Operating expenditures farm investment and, 121 Export parity price, 80-82. See also market price determinations and, 70 TRADED operating expenditure and, 123, 126 Export parity values, 252, 269, 271, procurement procedures and, 16 272-75 project preparation and, 418-19 Exports, 216 residual value and, 119 foreign exchange premium and, 248 Equity. An ownership right or risk in- indirectly traded items and, 269 terest in an enterprise. Equity CAPITAL price distortions in traded items and, is the residual amount left after de- 251-53 ducting total LIABILITIES (excluding tradable but nontraded items stockholders' claims) from total and, 265 ASSETS. Return to equity is an amount trade policy change and, 277, 278 received by an equity owner that is Extension (agricultural). A service usually expressed by one or another directed toward infanning farmers MEASURE OF PROJECT WORTH. In a about new agricultural technology, BALANCE SHEET, owners' equity is the techniques, practices, PRICE changes, SHARE CAPITAL paid in by the owners and the like of enterprise plus RETAINED EARNINGS. Extension services See CAPITAL intangible benefits and, 281 debt-equity ratio and, 208 poor project analysis and, 31-32 financial rate of return to, 209, 212 project preparation and, 424 owners', 192, 193, 195, 197 sensitivity analysis and, 365 return on (income ratio), 207 Externality. In PROJECT ANALYSIS, a South Nyanza example (sources-and- effect of a PROJECT felt outside the uses-of-funds statement), 198 project and not included in the valua- Espadas, Orlando T , 183 tion of the project In general, eco- Ethiopia, Agricultural Minimum Pack- niomists consider an externality to ex- age Project in, 249-50 ist when production or consumption European Community, 438 of a good or service by one economic Evaluation unit has a direct effect on the welfare benefit-cost ratio and, 346 of producers or consumers in another of past investment, 55 unit. Externalities may be either tech- project cycle and, 25-26 nologtcal or pecuniary. An example of Evapotranspiration. Loss of water from a technological externality might be soil due both to evaporation and to silting downstream caused by opening transpiration from the plants growing a land settlement project or training in the soil. of project workers who subsequently Excess capacity. The capability of an en- can be employed by others Project terprise to produce more product analysis usually tries to incorporate without any additional fixed COST. technological externalities, especially The economic cost of the OUTPUT nay costs, within the project accounts and GLOSSARY-INDEX 471 thus to change them from externalh- partial budgeting technique and, ties to project COSTS and BENEFITS 91, 141 For example, the increased cost of pattern farm investment analysis and, harbor dredging caused by increased 90, 93-94 siltation might be calculated and preparation of, 127-40 assigned to the land settlement proj- project preparation and, 418 ect. Pecuniary externalities arise when taxes and, 133 the project affects the PRICES paid or valuing labor and, 260 received by others outside the proj- valuing land and, 256 ect-for example, when higher prices whole farm, 287-89 must be paid by other users of fertil- Farmers, 17 izer as a result of increased demand aggregation methods and, 289 by project farmers. Pecuniary exter- benefits and, 56-57 nalities are usually excluded from benefits and disadvantaged, 132 both project FINANCIAL and ECONOMic cash position and, 134 ANALYSIS. cost recovery and, 224, 225, 427 debt services and, 135 Factor of production. An INPUT required financial impact and, 86 to produce OUTPUT. Primary factors of harvesting practices of Javanese production are land, labor, and small, 259 CAPITAL; secondary factors include interviewing, 92 materials, irrigation pumps, and the net benefit increase and, 140-41 like. objectives and, 44, 45 Families. See Farm families organization of, 31, 424 Family labor. In agricultural PROJECTS, poor project analysis and, 31 the labor of the farmer and members projected rate of return and poor, 27 of the family resident on the farm. rent recovery and, 229 Family members may work some- resource use (own) and, 129, 140 where other than the farm, in which separable costs-remaining benefits case the INCOME they earn may be method and, 240 OFF-FARM income. Compare with sharing of bulls and, 174 HIRED LABOR valuing land and, 256-57 farm budget and, 138-39 Farmers' Fertilizer Cooperative farm investment and, 123 (India), 400 farm investment analysis and, 90 Farm families. See also FAMILY LABOR labor use analysis and, 103, 105, 111 cropping patterns and, 139 project costs and, 53 financial aspects of projects and, 17 rent recovery and, 229 financial incentives and, 129 unit activity budgets and, 142, 146 home-consumed production and, 56 valuing labor and, 259, 260, 261 Farm family net benefit. The NET FAO. See Food and Agriculture Orga- BENEFIT of a farm family. "In- nization of the United Nations (FAO) cremental farm family net benefit" is Farm budget. In FARM INVESTMENT ANALY- the incremental net benefit. sis, a projection of the INFLOW and Farm gate. The boundary of a farm. The OUTFLOW of a farm to estimate the in- farm-gate PRICE is the price a farmer cremental NET BENEFIT over the life of receives for his product or pays for a PROJECT. Generally based on a INPUTS at the boundary of the farm- PATTERN FARM PLAN. See also Budgets that is, the price without any trans- aggregating, 287-89 port to a market or other marketing calculator use and, 406-07 service. Most commonly applied to debt service and, 133-38, 147 OUTPUTS. See Farm-gate price declining real burden of debt service Farm-gate price and, 159 determining market prices and, 70-71 family labor costs and, 138-39 economic import parity value farm investment analysis and, 89 and, 270 feed requirement analysis and, 187 export and import parity prices and, incremental net benefit and, 78, 81 127-32, 133 feed budget and, 187 land costs and, 139-40 operating expenditure calculation loan receipts and, 132-33, 134 and, 123 net benefit increase and, 140 rent recovery computation and, 229 472 GLOSSARY-INDEX Farm-gate price (continued) feed budget (herd projection) and, valuation and, 117, 118 183-87 Farm income See also INCOME flow chart for, 95, 97 analysis of, 89 herd growth and, 179-83 discounting assumptions and, 99 herd projection and, 113-15, 162-93 financial aspects of projects and, 17 herd projection work sheet and, 165, net benefit increase and, 140-41 166, 168-73 project preparation and, 426 herd stabilization and, 175-79 unit activity budget and, 141 incremental residual value and, variations in, 91 117-19 Farm income analysis. An analysis of a incremental working capital and, farm to check the current perfor- 126-27 mance of the farm. It is usually un- investment and, 119-23 dertaken for a one-year period (and so labor use and, 102-11 is undiscounted), uses CURRENT land costs and, 139-40 prices, includes an annual DEPRECIA- land use and, 99-101 TION charge, excludes OFF-FARM in- livestock and, 112-17, 163 come, and includes HOME-CONSUMED machine computation (herd projec- PRODUCTION. The performance criteria tion) and, 183 are the return to the CAPITAL and la- net benefit increase and, 140-41 bor engaged on the farm as indicated operating expenditure and, 123-26 by profit as a percentage of net worth preparing, 89-94 and family INCOME. Distinguished principal elements of, 96 from FUNDS FLOW ANALYSIS and FARM principal repayment and, 150-53 INVESTMENT ANALYSIS. simple interest calculation and, Farming systems, project preparation 147-50 and, 415-16 technical coefficients (herd projection) Farm investment analysis. An analysis of and, 165-80 a farm to determine the attractiveness unit activity budgets and, 141-47 of additional INVESTMENT in the farm. valuation of production and, 117 It is usually undertaken for the life of Farms. See also Pattern farms the investment and is therefore dis- farm investment analysis and size of, counted, uses CONSTANT prices, treats 90-91 CAPITAL by showing the initial invest- herd projection and small, 163 ment in the year it is anticipated and Feasibility study, 22-23 A study of a by including RESIDUAL VALUE at the proposed PROJECT to indicate whether end of the period analyzed, includes the proposal is attractive enough to cash and noncash farn INCOME, and lustify more detailed preparation. Of includes HOME-CONSUMED PRODUCTION. limited detail, but the amount of de- The perfonnance criterion is the re- tail included in feasibility studies turn to the additional resources en- varies widely. gaged as indicated by the NET Feed budget, 183-87 PRESENT WORTH, INTERNAL RATE OF Feed concentrates, 117 RETURN, NET BENEFIT-INVESTMENT Feed consumption, 112 RATIO, BENEFIT-COST RATIO, Or NET Feed requirements BENEFIT INCREASE. See also animal units and, 103-04, 174, 175 INVESTMENT feed budget and, 183, 185-87 accounting convention for, 95-99 Fertilizer, 15 animal units definition and, 174-75 crop response to nitrogen (Philippine computational convention in herd example) and, 65-69 projection and, 164-65 inappropriate technology and, 30 debt service computation and, 147-62 trade policy change example and, declining real burden of debt service 277-78 and, 159-62 Fess, Philip E., 190 equal installments calculations and, Final. With reference to goods and ser- 153-57 vices, those goods and services that family labor costs and, 138-39 are sold to the ultimate purchaser to farm budget and, 127-40 be used for consumption or as an farm production (projected) and, addition to the stock of fixed 111-19 CAPITAL-not 0s INPUTS to be further GLOSSARY-INDEX 473 transformed by some other produc- Financial price. See MARKET PRICE tion activity. The sum of all final Financial price adjustment goods and services is the GNP. Final export and import parity values and, goods have proceeded through the 252, 269-71 various stages of production as far as indirectly traded items and, 265-69 they will ever go-that is, they have nontraded items and, 253-65 reached their "final" form in a traded goods and, 251-53 physical sense. Distinguished from transfer payments and, 251 INTERMEDIATE goods, which must Financial prices, economic values deter- undergo further transformation before mination and, 243, 244, 245 they reach their final form, and in- Financial rate of return. The INTERNAL termediate services, which contribute RATE OF RETURN calculated using to a further production activity. A financial values. The internal rate of particular good or service may be return used in FINANCIAL ANALYSIS. See either final or intermediate depending also INTERNAL RATE OF RETURN; RATE on the use to which reference is OF RETURN made. Thus, an orange is a final good discount measures computation and, if consumed directly and an in- 357-58 termediate good if it is used to make farmer's own resources and, 129 orange juice. as financial measure, 209-12 Financial accounts internal rate of return and, 331 economic values determination and, project worth as, 128 244, 246 sensitivity analysis and, 364 foreign exchange premium and, 247 unit activity budget and, 147 Financial analysis. An analysis done Financial ratio. One of a group of ratios, using MARKET PRICES. Distinguished based on financial statements for an from ECONOMIC ANALYSIS. enterprise, that enable the project balance sheet (processing) preparation analyst to make a judgment about the and, 192-95 efficiency of an enterprise, its return economic analysis as complement on key aggregates, and its LIQUIDITY. to, 18 Often used in the analysis of CREDIT- farm investment analysis and, 85-86 WORTHINESS. In this book, the follow- financial rate of return (processing) ing financial ratios are discussed: and, 209-12 INVENTORY TURNOVER, OPERATING financial ratios (processing) and, RATIO, RETURN ON SALES, RETURN ON 202-09 EQUITY, RETURN ON ASSETS, CURRENT income statement (processing) and, RATIO, DEBT-EQUITY RATIO, and DEBT 195-97 SERVICE RATIO. incremental net benefit derivation computation example, 204-05 and, 317-18 creditworthiness, 207-09 labor and land prices and, 72-73 debt-equity, 208 market prices used in, 69 efficiency, 203-06 numeraire and, 244 income, 206-07 "pattern" accounts and, 85-86 use of, 202 predicting future prices and, 75 Financial results, project preparation processing industries overview and, and, 426-27 189-92 Financial statements project objectives and, 46-47, 86-87 accounts and, 190-92 sensitivity analysis and, 363 balance sheet, 190, 192-95 sources-and-uses-of-funds statement income, 190, 194, 195-96 (processing) and, 197-202 processing and, 189-90 taxes and, 54 sources-and-uses-of-funds, 190, World Bank's Project Preparation 198-202 Facility and, 441 Financing plan. In PROJECT ANALYSIS, a Financial aspects of projects, 16-18 budget showing CURRENT costs for a farm budget and, 129 project as opposed to the accounts financial rate of return as financial cast in CONSTANT terms used for most measure for, 209-12 of the analysis. Used to help a financ- project preparation and, 421-22 ing agency, such as the ministry of unit activity budget and, 146 finance, plan for the amount of 474 GLOSSARY-INDEX Financing plan (continued) project preparation reports and, 411 money needed year by year by the Foreign exchange. See also OFFICIAL PROJECT. Also, the plan for the va- EXCHANGE RATE rious sources of finance to be used for domestic resource cost and, 398-400 a project (the national budget, foreign shadow price of (economic values de- borrowing, EQUITY investment, and termination), 244 the like). Foreign exchange flow, 220-22 First Livestock Development Project Foreign exchange premium. The propor- (Syria), 47 tion by which the OFFICIAL EXCHANGE First-year return. An analytical technique RATE overstates the REAL value of local to determine the optimal time to be- currenc' or of NONTRADED goods and gin a proposed PROJECT. In this tech- services relative to TRADED goods and nique, the incremental NET BENEFIT services. Generally stated as a percen- stream (cash flow) in the first year it tage. In PROJECT ANALYSIS, generally is positive is divided by the total of the ratio of domestic prices divided by the incremental net benefit STREAM BORDER PRICES Used to calculate the (cash flow) in those years it is nega- SHADOW EXCHANGE RATE and the tive. The result expressed in percen- STANDARD CONVERSION FACTOR for tage terms is the first-year return. The ECONOMIC ANALYSIS, usually based on optimal time to begin the project is a weighted average TARIFF calculation the earliest year for which the in- in which the premium equals the rate cremental net benefit stream for a of the weighted average tariff The project begun in that year has a first- shadow exchange rate is derived by year return exceeding the OPPORTUNITY mufltplying I plus the foreign ex- COST OF CAPITAL. If the project begins change premium stated in decimal earlier, for at least the first year it will forn by the official exchange rate. In fail to earn the opportunity cost of economic efficiency analysis, the capital; if it begins later, a chance to standard conversion factor is the re- earn the opportunity cost of capital ciprocal of I plus the foreign ex- on the initial INVESTMENT will have change preinion. The foreign ex- been passed by. Postponing a project change premiuin is a form of "price can be advantageous only if the index" in which the "market basket" potential BENEFIT or COST STREAM Will varies according to the use for which increase independently of when the the iidex is intended. Specific conver- project begins, an uncommon condi- sion factors are similar indexes but tion in agricultural projects but a are narrowly defined to Include common one in road projects where smaller market baskets and are ap- traffic will grow independently of the plied to specific prices in the eco- time the project begins. The first-year nonc analysis of projects Mathe- return technique makes an implicit mnaticallv, the standard conversion assumption that once benefits begin factor is the weighted average of all they will be rising or constant. specific conversion factors; thus, the Fish catches, 15 standard conversion factor and the Fish production, poor project analysis shadow achange rate incorporate and drop in (Asia), 37 more aggregated estunates of the F.o b (free on board) prices. The price of effects of trade DISTORTIONS on the an export loaded in the ship or other project than do specific conversion conveyance that will carry it to for- factors or disaggregated measures of eign buyers. Compare with C.I.F. applyiug shadow exchange rates. In export and import parity prices project anal'sts, the foreign exchange and, 78 premiimn focuses onlv on the trade export and import parity values component of international pay- and, 269 ments; in other uses, the foreign ex- price distortions in traded items change preniuon may be defined to and, 253 include other payments as well. See Food and Agriculture Organization of also EFFICIENCY PRICE; INDIRECTLY the United Nations (FAO) TRADED; INDEX NUMBER computer use and, 408 conversion factor approach and, development bank cooperative pro- 248-49 grams of, 439-40 export and import parity values and, price information and, 77 270-71 (,LOSSARY-INDFX 475 indirectly traded items and, 266 Geographical location, project prepara- price distortions in nontraded items tion and, 414-15 and, 254 Ghana price distortions in traded items and, market price determination example 252-53 and,71 relationships within equation for, Upper Region Agricultural Develop- 249-50 ment Project in, 290, 291 traded goods and, 247-48, 249-50 GIGO. See Garbage in, garbage out prin- Forestry project (Tunisia), 386-88, 389 ciple (GIGO) Format. See Project format Gittinger, J. Price, 153, 158, 159, Franchise tax (income statement prepa- 163, 227 ration), 197 GNP. See Gross national product (GNP); Free on board. See F.O.B. (FREE ON BOARD) NATIONAL INCOME PRICES Goats, 175 Fuel, predicting future prices and, 75 Government, cash flow of, 217-20 Full development. With respect to a Government agencies, 17 PROJECT, the period in the life of the aggregation methods and, 289-91 project after the INVESTMENT PERIOD debt repayment and, 87 and the DEVELOPMENT PERIOD when a financial assessment and, 86 project is producing the maximum project preparation and, 422-23, 426 OUTPUT expected on a continuing Government expenditures and receipts, basis. project effects and, 215-17 Funds flow analysis, 88, 89, 90. An Government regulations, tradable but analysis of the cash INFLOW and nontraded items and, 265 OUTFLOW in an enterprise. With refer- Grace period. In credit transactions, a ence to farms, an analysis to deter- period during which a borrower need mine the farmer's LIQUIDITY. It is not repay PRINCIPAL and, sometimes, usually undertaken for the period of a INTEREST. (Depending on the lending loan repayment, is not discounted, conditions, the borrower may or may uses CURRENT prices, treats CAPITAL by not be required to pay interest, which including cash purchases and sales of may be CAPITALIZED during the grace capital items, includes the cash por- period.) The grace period begins at the tion of OFF-FARM income, and ex- time the loan is extended and con- cludes HOME-CONSUMED PRODUCTION. tinues for a year (or other ACCOUNTING The performance criterion is the cash PERIOD) or more. Thus, a four-year available to the farm famil' as ind- grace period for a loan received at the cated by cash surplus or deficit. Also end of project year I would mean that called "sources-and-uses-of-funds the grace period would be project analysis." Distinguished from FARM years 2 through 5, and the first repay- INCOME ANALYSIS and FARM ment of principal would be due at the INVESTMENT ANALYSIS. Used in de- end of project year 6. veloping and evaluating the FINANCING interest calculation (equal installment PLAN for the farm or other enterprise. repayment) and, 153 sources-and-uses-of-funds statement interest determination and declining and, 198, 202 real burden of debt service and, 162 Funds from operations. Revenue less Grading, 73 cash OPERATING EXPENSE and SELLING, project benefits and, 58 GENERAL, AND ADMINISTRATIVE Grant, Eugene, 341 EXPENSE. May also be determined as Grants, 132. A payment made to an indi- the sum of profit before INTEREST and vidual without expectation of goods TAXES plus DEPRECIATION and other or services in return. In PROJECT noncash OPERATING EXPENSES. ANALYSIS, generally a payment by a income statement and, 196, 197 government agency to an individual sources-and-uses-of-funds statement or firm to encourage a specific activ- and, 198 ity such as participating in a PROJECT or making an INVESTMENT. A grant is Garbage in, garbage out principle a TRANSFER PAYMENT. (GIGo), 9 Gross benefit. The incremental OUTPUT GDP. See Gross domestic product (GDP); from a PROJECT. NATIONAL INCOME Gross domestic product (GDP), national Gearing. See LEVERAGE income measures and, 292 476 GLOSSARY-INDEX Gross income, 196 worksheet for, 165, 166, 168-73 Gross national product (GNP), national High-yielding seed, 15, 365. See also income measures and, 292 YIELD Gross profit, 196. See also Profit Hired labor, 416. In agricultural Groundwater. Water beneath the surface PROJECTS, labor employed by a project of the soil that supplies wells and or a farmer that is other than that of springs. project participants or the farm fam- Guidelines for Project Evaluation (UNIDO ily and that is paid a wage, perhaps 1972), 246, 248 an IN-KIND PAYMENT. Distinguished Gunnerson, Charles G., 280 from FAMILY LABOR. Guyana, Sea Defense Project in, 47-48 farm investment and, 123 labor use analysis and, 103, 105-11 valuing labor and, 261-62 Harsh, Stephen B., 90 Hogs, 113, 163, 185 Health benefits, 280, 428 Home-consumed production, 56. Goods Heifers and services that are produced on a computational conventions and, farm and are consumed by the farm 164-65 family. The value of home-consumed culling rate and, 167 production is included in both defined, 163 FINANCIAL ANALYSIS and ECONOMIC feed budget and, 185 ANALYSIS in reaching the incremental herd growth and, 180, 181 NET BENEFIT. It is included among the stable herd determination and, FINAL goods and services that consti- 177, 179 tute NATIONAL INCOME. Helmers, F. Leslie C. H., 347 debt service calculation and, 134 Herd build-up. See HERD PROJECTION farm budget and, 132 Herd composition small farms and, 90 farm investment and, 123 Honduras, Agricultural Credit Project projected farm production and, 112, in, 150-51, 152 115, 116 House plot. On a farm, the area immedi- Herd productivity. The ratio of animols atelv surrounding the family resi- sold from a livestock herd plus the in- dence, it is often devoted to growing crease in herd size during a year over vegetables and similar crops, generally the number of animals in the herd at for home consumption. the beginning of the year. Housing Herd projection A forecast year by year farm budget calculations and, 132-33 of the number and class of animals market price determination and, in a herd or other grouping. See also 73-74 Livestock project benefits and, 59 adult mortality and, 166 animal units and, 174-75 calf mortality and, 166 calving rate and, 166 Ilocos Irrigation Systems Improvement computational conventions and, Project (Philippines), 319, 327, 328, 164-65 331, 332, 343, 347, 401 culling rate and, 166-67 Implementation feed budget and, 183-87 delays and, 28-29, 36 herd growth and, 179-83 mutually exclusive projects and, herd productivity and, 162, 183, 185- 381-83 86, 188 project analysis and problems with, machine computation and, 183 29-35 projected farm production and, project cycle and, 24-25 113-17 project preparation and, 418 purpose of, 163-64 reestimation and, 27 ratio of bulls to breeding cows and, sensitivity analysis and delay in, 364, 167-74 369-71 stable herd determination and, 175-79 Import parity prices, 78-80. See also technical coefficients and, 113, TRADED 115-16, 117, 165-74 Import parity values, 252, 269-71, terminology and definitions for, 164 276-77 GLOSSARY-INDEX 477 Imports given time period. In accounting, in- domestic resource cost and, 398 come is revenues less expenses. In- financial price adjustment (tradable come may be stated before TAX or af- but nontraded items) and, 263-65 ter tax; in the latter case it is often foreign exchange premium and, 248 called "net income." In a private en- indirect (valuing), 265-66, 267 terprise, income is profit. See also price distortions in traded items and, Farm income; NATIONAL INCOME 251-53 farm budget and off-farm, 132, 260 of raw materials (market price as esti- farm investment and family, 123 mate of economic value example), labor, 138 255-56 operating before depreciation trade policy change and, 276, 277, 278 (sources-and-uses-of-funds state- Import substitute, 252, 253. An OUTPUT ment), 198 of a PROJECT that replaces goods or operating and nonoperating (income services that would have been im- statement), 196 ported without the project. See also project objectives and, 45-46 TRADED of rural poor, 28 Improved pasture. Pasture in which the time value of money (discounting YIELD has been increased through a dimension) and stream of, 309-13 combination of measures such as undiscounted project worth measures planting higher-yielding grass species, and, 303-04 planting legumes, or spreading lime. water charges and, 225 See Pasture Income distribution. The pattern of the Impute. To determine a PRICE or division of total NATIONAL INCOME ECONOMIC VALUE by some computa- among the total population of a tion rather than by using an observed country. MARKET PRICE. To the extent possible, cost recovery and, 224 in PROJECT ANALYSIS it is desirable to economic analysis and, 20, 21 avoid imputed prices. By taking the economic values determination and, POINT OF FIRST SALE and using that as 245-46 a base for the price used in a project national objectives and, 44-45 analysis, the most serious weaknesses project impact on, 28 of imputed prices may be avoided. project preparation and, 413-14, 427 Such imputed prices as those for valuation and, 11 INTERMEDIATE GOODS, however, should Income ratio, 191, 206-07 be avoided whenever possible by de- Income statement. A financial report that fining the PROJECT BOUNDARY in such summarizes the revenues and ex- a way that it is at a point where a penses of an enterprise during an product can be priced or valued based ACCOUNTING PERIOD. It is thus a state- closely on a MARKET PRICE. Thus, wa- ment that shows the results of the op- ter in an irrigation project is not eration of the enterprise during the valued by means of an imputed price; period. Net INCOME, or profit, is what rather, the boundary of the PROJECT is is left over after expenses incurred in taken to be the FARM GATE, and the production of the goods and services BENEFIT of the project is based on delivered have been deducted from the FARM-GATE PRICES. Water, then, is revenues earned on the sale of these treated as an intermediate good with- goods and services. Thus, income in 'the project, and no price or value (profit) = revenues - expenses. is imputed for it. as basic financial statement, 190 Incentives, 89 example of, 194 assessment of, 86-87 financial rate of return and, 211, 212 cost recovery and, 225 preparation of, 195-97 financing and, 129, 134 Income taxes. See Taxes, income rate of return to equity after taxes Incremental cash flow. See Incremental and, 213 net benefit Income. The flow of goods and services Incremental net benefit. See also NET accruing to an individual or a group BENEFIT of individuals. NATIONAL INCOME is aggregation, 287-89, 291, 296 the sum of the FINAL goods and ser- debt service and, 134 vices produced by an economy in a derivation of, 315-19 478 GLOSSARY-INDEX farm budget and, 127-32, 133 added together directly rn a meaning- farm family and, 123 ful way. The method used to obtain financial rate of return calculation more meaningful indicators of the and, 210-12 average change is by weighting the internal rate of return and, 329, percentage changes for each commod- 332-35, 343 it)' according to its relative impor- mutually exclusive projects and, 379 tance. In the case of a "quantity in- negative, 341, 349 dex," for example, PRICES are used as net benefit increase and, 140 a measure of the relative importance net benefit-investment ratio and, of the change in quantities of dtffer- 347-49 ent commodities. In the case of a net present worth and, 327 "price index," quantities purchased from operations (income state- are used as weights. ment), 196 India unit activity budgets and, 142, 143, Cashew Project in, 142-46, 146, 147 157-58,406 valuing land and, 256 Drought Prone Areas Project in, 289 Incremental operating expenditure, 98 Farmers' Fertilizer Cooperative Proj- incremental working capital and, ect in, 400 126, 127 Indus Basin Project in, 10 Incremental residual value. See also Maharashtra Irrigation Project in, RESIDUAL VALUE 223, 227-28, 229-32, 397 farm budget and, 133 shadow wage rate and, 262 projected farm production and, Smallholder Dairy Improvement Proj- 117-19, 121 ect in, 57 Incremental working capital. See also Indirect benefit. A form of BENEFIT that WORKING CAPITAL IS SECONDARY. Changes in INCOME that accounting convention and, 98-99 accrue to sellers of project INPUTS (So- farm budget and, 133 called INDUCED-BY, or "backward- farm investment analysis and, 126-27 linked," benefits) or to buyers of proj- unit activity budget and, 143 ect OUTPUTS used as INTERMEDIATE Independent. PROJECTS or project design goods (so-called STEMMING-FROM or options that can all be undertaken. "forward-hnked," benefits). An Distinguished from MUTUALLY alternative to the use of SHADOW EXCLUSIVE projects or project design PRICES. In general more narrowly options, for which accepting one defined than secondary benefits. alternative necessarily excludes Used primarily in water resource accepting another. programs in the United States. Index number. An index number is a Indirectly traded items. Refers to a ratio that measures the magnitude of NONTRADED item that has a high im- one economic aggregate in relation to port content. Examples include locally the magnitude of a comparable aggre- assembled tractors that partly use for- gate at a different point in time or eign components and construction place. The point of reference is called that uses imported reinforcing rods. the "base." In time series, the "base Valued by DECOMPOSITION (or breaking period" is usually a particular year, down) the FACTORS OF PRODUCTION perhaps one regarded as typical. The used in the indirectly traded item into value of the aggregate in the base TRADED and nontraded components, period is equated with 100, so that which are then valued separately in the index number for the year being the ECONOMIC ANALYSIS using either a measured (called the "current year") SHADOW EXCHANGE RATE or a readily gives the percentage change CONVERSION FACTOR, to allow for the between the base period and the cur- FOREIGN EXCHANGE PREMIUM. Specific rent year. Index numbers can be used conversion factors are sometimes to show percentage changes in calculated for major indirectly traded homogeneous aggregates such as total items commonly used in PROJECTS. quantities ofa single commodity or financial price adjustment and, the total value of output or expendi- 265-69 ture. Their main use, however, is to price distortion in traded items measure changes in the aggregates or and, 253 averages of things that cannot be Indirect tax. See TAX GLOSSARY-INDEX 479 Indirect transfer payment. See TRANSFER comparison with the others so that PAYMENT the relative prices of these specified Indonesia, Jatiluhur Irrigation Project costs and benefits change. Using con- in, 337, 365-71 stant prices allows the analyst to Induced benefit. A form of MULTIPLIER avoid making risky estimates of fu- benefit that occurs through the Keyne- ture inflation rates and to simplify the sian (or "respending") multiplier, analytical procedures. which operates on consumption ex- contingency allowances and, 53, 54, penditures. Generally considered to 393-94, 395 double-count the BENEFITS of a debt service and, 135-38 PROJECT and thus is not commonly declining real burden and, 158-62 used. financial planning and, 87 Induced-by benefit. A form of INDIRECT government cash flow and, 217-19 BENEFIT that accrues to suppliers of measures of project worth (current project INPUTS. Includes the direct prices) and, 400-01 and indirect VALUE ADDED to NATIONAL predicting future prices and, 76-77 INCOME generated by the INVESTMENT Inflow. All payments, goods, and services and RECURRENT expenditures of a of value that are received or produced PROJECT. Equivalent to using a by an enterprise and that increase SHADOW PRICE for a project input for NET BENEFIT. In FARM BUDGETS in- which an adjiustment is made for tended for FARM INVESTMENT ANALYSIS, OPPORTUNITY COST in the estimates of includes HOME-CONSUMED PRODUCTION direct and indirect value added. and OFF-FARM income. Distinguished Sometimes estimated using special- from OUTFLOW. ized forms of input-output multi- Infrastructure pliers. See STEMMING-FROM BENEFIT Korean project for, 281-84 Induced cost. An uncompensated adverse poor project analysis and, 31-32 effect caused by the construction and project preparation and, 417, 418 operation of a PROJECT. Used in U.S. In-kind payment. A payment-in general, government practice for computing wages or a payment for cultivation the BENEFIT-COST RATIO at MARKET rights-made in the form of goods or PRICES. services rather than in money. Indus Basin Development Project (India Input. A good (such as seed or fertilizer) and Pakistan), 10 or service (such as agricultural labor) Industrial projects, 255 used to produce an OUTPUT (such as excess capacity and, 263 crops or livestock). Inflation, 216. An increase in the general commercial aspects of projects PRICE level of an economy. Inflation and, 16 occurs when the quantity of money in incremental working capital, 126-27 circulation rises relative to the investment, 119-23 quantity of goods and services operating expenditure, 123-26 offered. The result is "too much predicting future prices and, 75 money chasing too few goods," and project preparation and, 416, 424 prices are bid up. At high rates of in- Inspection, ranking projects by, 300-01 flation, people tend to lose confidence Institutional aspects of projects, 13-14 in money, and the quantity of money project preparation and, 414, 417 in circulation increases relative to ex- Institutional assistance (project prepara- penditures in CURRENT prices as peo- tion), 437-43 ple tend to hold (hoard) goods rather Insurance, market value as estimate of than money. Inflation is associated economic value and, 256 with _d rise in gross national expendi- Insurance scheme (herd), 116 ture at current prices that is greater Intangible. In PROJECT ANALYSIS, refers to than the increase in the REAL supply a COST or BENEFIT that, although hav- of goods and services available. In ing value, cannot realistically be PROJECT ANALYSIS, the customary assessed in actual or approximate analytical approach is to work in MONEY TERMS. Intangible benefits in- CONSTANT prices rather than current clude health, education, employment prices and to assume that inflation generation, electricity used for home will affect the prices of all COSTS and lighting, and the value of domestic BENEFITS equally, except for specified water supply. Intangible costs are costs and benefits that are varied in often the absence of the related ben- 480 GLOSSARY-INDEX Intangible (continued) goods proceed further through the efit-disease, illiteracy, and so forth- production system and are used by but may also be such items as en- other enterprises as an input. Distin- vironmental degradation, inconveni- guished from FINAL goods and ser- ence, and the like. Intangible benefits vices, which have reached their ulti- are sometimes valued as being at least mate form for use in consumption, or equal to the estimated cost of the best as an addition to fixed capital. A par- alternative method of providing the trcular good or service may be either same benefit. Thus, the benefit of sup- final or intermediate depending on the plying electricity for home lighting use to which reference is made. Thus, from a MULTIPURPOSE river basin an orange is an intermediate good if PROJECT may be taken to be the cost used to make orange juice and a final of providing the electricity by diesel good if consumed directly. generators. This method of Intermediate goods, market price deter- ALTERNATIVE COST VALUATION should mination and pricing of, 71-72 be used only in cases where the Interest. A payment for use of money, alternative actually would be under- generally stated as a percentage of the taken in the absence of the project. amount (PRINCIPAL) borrowed The The TANGIBLE cost of avoiding an in- rate of interest is also used for tangible cost may be included in the DISCOUNTING; in that use it generally cost of a project. Thus, the cost of is referred to as the DISCOUNT RATE avoiding downstrean pollution fron "Simple interest" is the interest paid excessive fertilizer run-off may be in- in one period; compound interest is cluded in the cost of a project as a interest paid not only on the amount means of dealing with the intangible borrowed but on the interest earned cost of pollution. However, the nature in previous periods For methods of of intangible costs and benefits is computation, see COMPOUNDING such that REAL value of the cost to FACTOR FOR I and DISCOUNT FACTOR. those bearing it or of the benefit to benefit-cost ratio and, 345 project participants cannot be deter- capitalized equal installments and, mined. When intangible costs or ben- 157-58 efits are encountered in project analy- compounding of, 305-08 sis, the analyst should identify them computing debt service and, 147-50 and quantify them to the extent possi- declining real burden of debt service ble. Projects in which a substantial and, 158, 161-62 amount of the benefit is intangible economic analysis and, 19 may be evaluated using COST EFFEC- equal installment repayment and, TIVENESS ANALYSIS See EXTERNALITY 153-56 Integrated rural development project. A foreign exchange flow and, 222 PROJECT in which a conscious government cash flow and, 219, 220 attempt is made not only to increase income statement and, 196-97 agricultural production in a rural internal rate of return and, 331, area, but also to improve INPUT and 335, 343 OUTPUT marketing and the quality of payments (sources-and-uses-of-funds rural life. statement), 199, 202 Inter-American Development Bank, project costs and, 54-55 411, 441 received (sources-and-uses-of-funds Intermediate. With reference to goods statement), 199 and services, those goods and services time value of money (discounting that are used as an INPUT for further dimension) and, 305-08 transformation by some other produc- unit activity budget and, 146 tion activity-not for consumption or Internal rate of return, 210, 299, 343, as an addition to the stock offixed 358, 401. A discounted MEASURE OF CAPITAL. Intermediate goods are an PROJECT WORTH. The DISCOUNT RATE OUTPUT of one economic enterprise that just makes the NET PRESENT that have not yet reached the final WORTH of the incremental NET form in which they will be used as an BENEFIT stream, or incremental cash item of consumption or as an addi- flow, equal zero. The maximum tion to the stock of fixed capital. Such INTEREST that a PROJECT can pay for GLOSSARY-INDEX 481 the resources used if the project is to Inventory. Supplies of raw materials, recover its INVESTMENT and OPERATING finished goods, or goods in process EXPENSES and still just break even, that are held by an enterprise. Inven- "The rate of return on capital out- tories sometimes include spare parts standing per period while it is in- for machinery and equipment. vested in the project" (Merrett and creditworthiness ratios and turnover Sykes 1963, p. 38). For a formal of, 208 mathematical definition, see the efficiency ratios and turnover of, 203 appendix to chapter 9. Often abbrevi- increases and decreases in, 200-01 ated IRR. When using the internal rate incremental net benefit before financ- of return, the selection criterion is to ing calculation and, 212 accept all INDEPENDENT projects with Inventory turnover ratio. The cost of an internal rate of return greater than goods sold divided by the inventory. A the CUT-OFF RATE, which generally is FINANCIAL RATIO used to judge the OPPORTUNITY COST OF CAPITAL. May efficiency. give incorrect ranking among inde- Investment, 4, 5, 140, 246. In PROJECT pendent projects. Cannot be used ANALYSIS, use of resources for a pro- directly for choosing among ductive activity from which an MUTUALLY EXCLUSIVE alternatives. INCOME is expected to flow at a future comparison and ranking of, 358-61 time. In DISCOUNTED CASH FLOW computing, 332-39, 358 ANALYSIS, investment is defined mathe- depreciation and, 351, 353 matically as a negative incremental financial and economic rates of return NET BENEFIT, or incremental cash and, 331 flow, occurring for any ACCOUNTING incremental net benefit derivation PERIOD. See also FARM INVESTMENT and, 317 ANALYSIS interpolating value of, 336-39 benefit-cost ratio and, 345 mutually exclusive projects and, 375, civil works and, 53 377-79, 383 economic values determination point in time for calculation of, and, 244 341-43 farm input analysis and, 119-23 possibility of more than one, 339-41 internal rate of return and, 339 project selection and, 350-51 mutually exclusive projects and, 383 reinvestment of returns and, 339 net benefit and, 210 replacement costs and, 395 on-farm (project preparation), 418 switching value method and, 371 optimization (net benefit-investment as useful measure of project worth, ratio) of, 349-50 329-32 planning and, 6 International associations, price in- project form and, 8 formation and, 77-78 project implementation and, 25 Internationally traded commodities, project preparation and, 421 prices for, 77-78 project purposes and, 390 Interpolation, 332. Estimation of values return on (income ratios), 206 (of a function) between two known secondary costs and benefits and, values. "Linear interpolation" refers 60, 61 to a procedure of estimation that sensitivity analysis and, 369 assumes that the function connecting sources-and-uses-of-funds statement two known values is a straight line. and, 198, 199 In this book, the most common- sunk costs and, 55 although not the only-use of inter- technical life of major, 355 polation is to estimate the INTERNAL undiscounted project worth method RATE OF RETURN when it lies between and, 300-04 two known values of the NET PRESENT unit activity approach to, 141, 143 WORTH obtained by DISCOUNTING the Investment Centre (FAo), 411, 439, 440 NET BENEFIT stream at two different Investment period. With respect to a DISCOUNT RATES. PROJECT, the period when the major value of internal rate of return and, project INVESTMENTS are undertaken. 336-39 In agricultural projects, often three to Interviews (farmer), 92 five years. 482 GLOSSARY-INIDEX Ireson, W. Grant, 341 Third Agricultural Credit Project in, IRR. See INTERNAL RATE OF RETURN 140-41, 147-50 Irrigation Third Highway Loan Project in, aggregation methods and projects 382-83 for, 290 Korea, Rural Infrastructure Project in, cost recovery example and, 223-24 281-84 cost recovery measure and, 227-28 environmental impact and, 15-16 excess capacity (industrial projects) Labor. See also FAMILY LABOR; HIRED and, 263 LABOR joint cost allocation example and, aggregation methods and, 294, 296 233-40 farm investment analysis and, 90, new technologies and, 30 102-11 poor project analysis and, 36-37 income statement and, 196 project delays and, 29 market price determination and, project preparation and, 415 72-73 rate of return estimates and, 27 predicting future prices and rural, 76 rent recovery measure and, 229-32 project costs and, 53 residual value and, 398 unit activity budgets and, 141, 142, small schemes vs. large schemes 143, 146 (selection method), 377-79 Labor value, financial price adjustment water as an intermediate good and, 72 and, 258-63 Irvin, George, 300 Lagged annuity. Lagged annuity factor. See PRESENT WORTH OF A STREAM OF Jamaica Tall Coconut Project, 58-59 FUTURE INCOME James, L. D., 240 Land Jatiluhur Irrigation Project balance sheet and, 195 Indonesian example and, 337, farm budget and, 139-40 365-71 market price determination and, 72 Javanese example and, 260, 261 project costs and, 53 Java project preparation and, 415, 427 harvesting practices of small farmers tax on (farm budget), 133 in, 259, 261 unit activity budgets and, 142, 143 Jatiluhur Irrigation Project in, Land improvement, 121 260, 261 Land reform, 424 Joint costs. In a PROJECT ANALYSIS, project Land tenure. See Tenure COSTS that serve more than one pur- Land use pose in a MULTIPURPOSE project. An farm budget and, 139 eample is a dam that provides irriga- farm investment analysis and, 99-101 tion, power, and flood control. To project preparation and, 415 allocate joint costs, the SEPARABLE Land value COSTS-REMAINING BENEFITS method fnancial price adjustment and, 256- may be used. 58 residual value and, 119 general principles of allocation of, Lest-cos aalyi See COS 233-34 Least-cost analysis. See COST separable costs-remaining benefits EFFECTIVENESS ANALYSIS method and allocation of, 234-40 Least-cost combination method, 280-81 Julius, DeAnne S., 280 Lee, R. R., 240 Leisure, 139 Level payment. See ANNUITY; EQUAL Kalbermatten, John M., 280 INSTALLMENTS Kay, Ronald D., 90 Leverage. Use of borrowed CAPITAL to in- Kemubu Irrigation Project (Malaysia), crease the return to EQUITY. Some- 49, 50, 256-57 times called "gearing." Kenya Liability. A claum held by creditors Cotton Processing and Marketing Proj- against the ASSETS Of an enterprise; in ect in, 371-73 other words, the outstanding debts of South Nyanza Sugar Project in, the enterprise. "Current" liabilities 190-209, 217-22 are debts such as ACCOUNTS PAYABLE, GLOSSARY-INDLX 483 SHORT-TERM loans, current maturities Loans. See also Credit; DEBT SERVICE due on term loans, and income TAXES balance sheet preparation and, 195 that fall due within a year. "LONG- capitalized interest and, 157-58 TERM" liabilities are debts such as computing debt service and, 147 MEDIUM-TERM and long-term loans direct transfer payments and, 50, 52 and SUPPLIERS CREDITS that become efficient resource use and, 86 payable after one year from the date equal installment payment calcula- of the BALANCE SHEET. tions and, 153-56 balance sheet preparation and, government cash flow and, 219, 220 192-93, 195 repayment of equal amounts of prin- debt service coverage ratio and, 208 cipal and, 150-53 Life of project. See Project life simple interest calculations and, 150 Lilongwe Development Program (Ma- social effects example (West Africa) lawi), 356 and, 32 Linear programming, 93. A mathema- sources-and-uses-of-funds statement tical method of determining an op- and, 199, 202 timal combination of INPUTS to maxi- unit activity budget and, 146 mize (or minimize) and objective in Location, project preparation and, which the input variables involved 414-15 are subject to constraint. In agri- Location of sale change, 57-58 cultural projects, occasionally used to Lome Convention, 438 optimize CROPPING PATTERNS to maxi- Long-term. Occurring over a relatively mize INCOME. In practice requires a long period. Often taken to be more computer. than one year. In economics, a period Liquidity. The readiness with which an sufficiently long to depreciate fully ASSET can be converted into cash. and replace plant and equipment. In Little, I. M. D., 20, 21, 246, 247, 249, rural credit PROJECTS, a category of 254, 267 MEDIUM-TERM loans will be found. Livestock. See also HERD PROJECTION These often have a term of two to five aggregation method and, 291 years and are made to enable farmers climate and poor project estimates to purchase equipment such as for, 36 pumps, which have a life of five to farm investment and, 121-23 ten years. The designation "long- farm investment analysis and, 92 term" loans, then, would be reserved incremental working capital for, 127 for periods of more than ten years; insurance scheme and, 116 such loans are often made to enable labor use analysis and, 103-05 farmers to purchase land. Distin- operating expenditure and, 123 guished from SHORT-TERM projected farm production and, Long-term liability. See LONG-TERM and 112-17 LIABILITY project preparation and, 415, 418 Loss avoidance, 58-59. A loss that would residual value and, 119 have occurred without a PROJECT and unit activity budgets and, 141, 142 that is avoided as a result of the proj- Livestock and Agricultural Development ect. A loss avoided is a BENEFIT at- Project (Paraguay). See Paraguay tributable to the project. Livestock and Agricultural Develop- Loughlin, James C., 240 ment Project Lower Egyptian Drainage Project, 59 Livestock Development Project (Ecuador), 57 Loan receipts McDiarmid, Orville John, 259 computing debt service and, 147 McKean, Ronald N., 346 debt service and, 134, 135 Maharashtra Irrigation Project (India) declining real burden of debt service cost recovery and, 223, 227-28 and, 159, 161 rent recovery and, 229-32 farm budget and, 129, 132, 133 replacement costs and, 397 foreign exchange flow and, 222 Malawi, Lilongwe Development Pro- government cash flow and, 219 gram in, 356 unit activity budget calculations Malaysia, Kemubu Irrigation Project in, and, 146 49, 50, 256-57 484 GLOSSARY-INDEX Managerial aspects of projects, 14-15 the MARKETING SERVICES needed in a project preparation and, 422-24 relatively competitive market. When Managers, 206 the marketing entity can influence aggregation and remuneration of, prices, the marketing margin may ex- 294-95 ceed the cost of the marketing ser- calf mortality rate decrease and, 166 vices. competence of, 87 Marketing services. Services needed to project evaluation and, 25-26 make the OUTPUT of an enterprise project implementation by, 25 (say, a farm) available to consumers project performance and, 33-34 in a form they prefer. Might include rate of return and, 86 processing (or other transformation of rent recovery and, 231 form), storage, transport, financing, sensitivity analysis and, 369 and risk bearing. steps in project analysis and, 37-40 Marketing structure, project preparation Manual for Preparing and Appraising and, 423, 425-26 Project Dossiers (Commission of the Marketing systems European Communities 1980), 438 imperfect, 60 Manual on the Use of Consultants in De- poor project analysis and, 31, 32 veloping Countries (UNIDO 1972), 441, Market price. A PRICE at which a good or 442, 443 service is actually exchanged for Maps (project preparation), 415 another good or service (as an IN- Marginal analysis. Analysts of the change KIND PAYMENT) or for money (in in one variable when a small change which case it is a financial price). A is made in another variable. An ex- market price can refer to a transac- ample of application is the MARGINAL tion that occurs at any location, not VALUE PRODUCT, which is the amount necessarily a village or wholesale OUTPUT-perhaps rice-is changed market. Distinguished from SHADOW when a small change is made in an PRICE INPUT-perhaps fertilizer-all other Market prices inputs being held constant. Marginal cost recovery and, 226 analysis is an important concept crossover discount rate example underlying most ECONOMIC ANALYSIS. and, 388 "On (or at) the margin" refers to a economic analysis and, 19 small change in the total of some in- economic values and, 243, 245, 246 put or output. as estimate of economic value, 254-56 Marginal cost. The incremental total COST financial analysis based on, 85 associated with producing one addi- financial price adjustment (nontraded tional unit of OUTPUT. See MARGINAL items) and, 253-56 ANALYSIS finding of (brief overview), 69-70 Marginal revenue product. See MARGINAL first-sale price and farm-gate price VALUE PRODUCT and, 70-71 Marginal value product, 75 The value of government cash flow account additional OUTPUT generated by an and, 217 additional unit of variable INPUT. Also indirectly traded items and, 265 called "marginal revenue product." If joint cost allocation and, 233 using one additional kilogram of managers and, 86 elemental nitrogen results in an in- price distortions and, 251, 253-54 crease in rice production worth 12.30 pricing intermediate goods and, 71-72 currency units, then the marginal problems in determining, 72-74 value product of a kilogram of project analysis and, 37, 40 elemental nitrogen is 12.30 currency project boundary price and, 74 units. tradable but untraded items and, 264 prices as reflection of value and, Materiality. The quality of being large 65-69 enough to affect decisions. A concept Marketing margin. The difference be- used in accounting. tween the PRICE a buyer pays for a Measure of project worth. A summary good or service and the price at measure of the contribution a which he sells that good or service. In PROJECT will make to the objective of general, equal to the cost of providing a participant in the project. In gen- CLOSSARY-INDEX 485 eral, a measure of earning capability Money terms. The monetary PRICES Of or of changes in INCOME, including goods and services. Distinguished NATIONAL income for the economy as from REAL terms, which refer to the a whole. Undiscounted measures of physical, TANGIBLE characteristics of project worth discussed in this book goods and services. are RANKING BY INSPECTION, PAYBACK Monopolistic. With reference to a market, PERIOD, PROCEEDS PER UNIT OF OUTLAY, a situation in which there is one (or AVERAGE ANNUAL PROCEEDS PER UNIT a few) buyer or seller who therefore OF OUTLAY, and AVERAGE INCOME ON may be able to affect the MARKET BOOK VALUE OF INVESTMENT. Dis- PRICE materially. A monopolistic counted measures of project worth MARKETING MARGIN occurs when the discussed are NET PRESENT WORTH margin between what a marketer pays (NPW or NPV), INTERNAL RATE OF for a good or service and what he RETURN (IRR), BENEFIT-COST RATIO (B/c sells it for is greater than would exist RATIO), and the NET BENEFIT- if there were many buyers and sellers INVESTMENT RATIO (N/K RATIO). in the market, all with good knowl- application of, 350-51 edge, and if a situation approaching benefit-cost ratio and, 299, 342, perfect competition were to exist. A 343-46 monopolistic market is a form of im- computation guidelines for, 356-58 perfect competition. Economists current prices and, 400-01 sometimes refer to a market where depreciation and, 351-55 there are several-but still a relatively discounted measures comparisons limited number-of buyers or sellers and, 358-61 as oligopolistic. discount measure considerations and, Morocco, Doukkala II Irrigation 299-300, 308-09, 313 Project, 150 discount rate choice and, 313-15 Mortality economic life of project and, of adult animals, 163, 166 355-56, 357 of calves, 116, 163, 164, 165, 166, 176 income streams and, 309-13 Mortality rate. With reference to live- incremental net benefit (derivation of) stock, the proportion of animals at and, 315-19 the beginning of a time period that interest and, 305-08 die during the period. Generally ex- internal rate of return and, 299, pressed as a percentage. 329-43 Most probable outcome. The value of a mathematical formulation of, 361 MEASURE OF PROJECT WORTH when the mutually exclusive projects and, most probable value of every element 373-93 in the project is used to calculate the net benefit-investment ratio and, measure. Compare with SENSITIVITY 356-50 ANALYSIS and RISK ANALYSIS as net present worth, 128, 299, 319-33 Multiple cropping. Growing more than project analysis and, 315 one crop on the same area in a year. sensitivity analysis and, 363-71 Multiplier. In macroeconomics, the pro- time value of money dimension in dis- portionate increase in NATIONAL counting and, 304-15 INCOME (in the form of consumption undiscounted measures of, 300-04 of FINAL goods and services) that Mechanization, benefits from, 58 occurs from each unit increase in Medium-term. In rural credit projects, new spending from some "auton- generally refers to loans extending two omous" source such as private to five years. See LONG-TERM; SHORT- INVESTMENT, the government, or the TERM. outside world (through exports). The Merrett, A. J., 300, 341 sum total of all additional consump- Mexico, 10 tion induced by the initial spending Meyn, Klaus J., 163 generally exceeds the amount of the Migration, project preparation and, initial spending itself The quantita- 416-17, 427 tive measure of this additional con- Mirrlees, J. S., 20, 21, 246, 247, 249, sumption relative to the initial in- 254, 267 crease in investment spending is the Mishan, E. J., 59 multiplier. Many variants of the basic 486 GLOSSARY-IN DEX Multiplier (continued) sult: (1) the value of all expenditure multiplier can be calculated Not on final goods and services produced generally used in PROJECT ANALYSIS be- (plus an allowance for HOME- cause of the difficulty of avoiding CONSUMED PRODUCTION), less imports; double counting of BENEFITS. SHADOW (2) the sum of all payments to PRICES that include carefully traced FACTORS OF PRODUCTION including an indirect changes in VALUE ADDED in- allowance for CAPITAL consumed by clude the multiplier effects while productive activities, and (for a minimizing the danger of double MARKET PRICE measure) all indirect counting Their use is therefore the TAXES net of SUBSIDIES; and (3) the approach preferred by many project sum of the VALUE ADDED from every analysts. producing unit. Narrowly defined, Multipurpose projects. Projects that serve national income excludes several purposes and are character- DEPRECIATION and indirect business ized by JOINT COSTS. taxes such as excise taxes and sales additional purposes in, 388-93 taxes. In this book, the broader defini- intangibles and, 281 tion is used. See also INCOME joint cost allocation and, 233, 234 aggregation and measures of, 292, Mutually exclusive projects. In PROJECT 293, 294, 296 ANALYSIS, refers to PROJECTS or project economic analysis and, 19 design options that, by their very na- trade policy changes and, 276-78 ture, are such that if one is chosen National objectives See also Objectives the other cannot be undertaken Ex- costs and benefits and, 44 amples include surface irrigation de- project identification and, 22 velopment, which rules out tubewell social aspects of projects and, 15 irrigation, or the same project begun Negative. With reference to cosTs or in alternative years. Distinguished BENEFITS, refers to a value in a COST from INDEPENDENT projects or project Or BENEFIT STREAM that is opposite in design options. sign to the sign normally associated entirely different projects and, 377-79 with the stream. In the earl' years of instances of, 375-77 a PROJECT, for example. the in- internal rate of return and, 375 cremental NET BENEFIT, or cash flow, multipurpose projects and, 388-93 stream generally is negative, so that net present worth and, 373-75 each of the first few entries is a nega- project scale and, 379-81 tive benefit, or negative cash flow-- technology and, 383-88 which is, of course, a cost. In an timing of project and, 381-83 INCOME STATEMENT, among the nonoperating income and expenses INTEREST received may be listed as a National development plan negative entry, in effect a negative project identification and, 22 cost-which is, of course, a benefit to social aspects of, 15 the enterprise Such seeming anoina- National income. The total net earnings hes or internally inconsistent terms of labor and property employed in the arise because it is convenient to production of goods and services in a group kinds of entries in one place in nation during a period, usually a a PROJECT ANALYSIS Thus, it is conve- year. Broadly defined, it is commonly nient to have an incremental net be- measured by the GDP (gross domestic nefit stream as the basis for calculat- product) or the GNP (gross national ing the INTERNAL RATE OF RETURN product). GDP is the value of the gross even though there are costs included output of all goods and services pro- in what is called a benefit stream, and duced in a nation less the value of it is convenient to group both interest INTERMEDIATE goods (those used to receipts and payments at one place in produce the goods or services). GNP is an income statement. the same as GDP, except that it in- Negative benefit, 318 cludes INCOME earned abroad and ex- Negative costs, 290 cludes income transferred out of the Net benefit In PROJECT ANALYSIS, the country by foreign owners. GDP can be amount remaining after all OUTFLOWS measured in three ways, all of which are subtracted from all INFLOWS. May are equivalent and give the same re- be negative. The net cash flow. The CLOSSARY-INDEX 487 incremental net benefit is the increase the present worth of the net benefit af- in net benefit with the PROJECT as ter financing without the project, ex- opposed to the case without the pro- pressed in percentage terns. ect. It is the incremental cash flow. Net benefit-investment ratio (N/K ratio), In the early years of a project, the net 209, 291, 299, 401. A discounted incremental benefit usually is nega- MEASURE OF PROJECT WORTH. The tive. The net incremental benefit is the PRESENT WORTH of the NET BENEFITS basis for calculating MEASURES OF divided by the present worth of the, PROJECT WORTH, the most important INVESTMENT. A form O BENEFIT-COST of which are the discounted measures RATIO. Calculated by taking the net ofNET PRESENT WORTH, INTERNAL RATE benefits as the net present worth of OF RETURN, and NET BENEFIT- the incremental net benefit (cash flow) INVESTMENT RATIO In reaching these STREAM in those years after the stream measures (usually called DISCOUNTED has turned positive and the invest- CASH FLOW ANALYSIS), COSTS are en- ment as the present worth of the in- tered in the year they are incurred, cremental net benefit (cash flow) and BENEFITS are entered in the year stream in the early years of a project they are realized. As a result, no when it is negative. For a formal DEPRECIATION is deducted before arriv- mathematical definition, see the ing at the incremental net benefit. In appendix to chapter 9. Often abbrevi- building project accounts for ated N/K ratio. When using the net FINANCIAL ANALYSIS, the net benefit benefit-investment ratio, the selection and incremental net benefit may be criterion is to accept all projects with derived as (1) the net or incremental a net benefit-investment ratio of I or "net benefit before financing," in greater when discounted at a suitable which case any financing transaction DISCOUNT RATE, most Often the is excluded, and (2) as the net or in- OPPORTUNITY COST OF CAPITAL, in order cremental "net benefit after financ- of ratio value until all available in- ing," in which case loans or other vestment funds are exhausted. May be financial receipts are added to the net used to rank INDEPENDENT projects. and incremental net benefits and DEBT Generally cannot be used directly to SERVICE or other financial payments choose among MUTUALLY EXCLUSIVE are subtracted from the net and in- alternatives. cremental net benefits. DISCOUNTING analysis of, 346-50 the incremental net benefit before comparisons and ranking of, 358-61 financing gives a measure of project computation of discounted measures worth of all resources engaged; dis- and, 358 counting the incremental net benefit depreciation and, 351, 355 after financing gives a measure of future prices and, 364 project worth of the entity's own re- incremental net benefit derivation sources or EQUITY. See BENEFIT; COST; and, 317 Incremental net benefit; NET BENEFIT mutually exclusive projects and, 373, entries. 377-81 farm budget and increase in, 140-41 project selection and, 346-47, 349, internal rate of return computation 350, 351 and, 332 replacement costs and, 395 rent recovery and, 229, 232 residual value and, 397, 398 Net benefit after financing, 129, 133 Net benefit-investment ratio of all re- debt service and, 134 sources engaged, 128 financial rate of return and, 212 Net financing, 212. Loan receipts less unit activity budget and, 147 DEBT SERVICE, the payment of Net benefit before financing, 127, 133 INTEREST, and repayment of debt service and, 134 PRINCIPAL. financial rate of return and, 210-11 Net present value. See NET PRESENT unit activity budget and, 146 WORTH Net benefit increase. A measure of addi- Net present worth, 140, 210, 299, 343, tional BENEFIT received, generally ap- 401. A discounted MEASURE OF plied to farmers. The PRESENT WORTH PROJECT WORTH. The present worth of of the incremental NET BENEFIT after the incremental NET BENEFIT, or in- financing with the PROJECT divided by cremental cash flow, STREAM of a 488 GLOSSARY-INDEX Net present worth (continued) actly the same pattern for all alterna- PROJECT The present worth of the tive projects. Otherwise, the values of BENEFITS less the present worth of the the ratios cannot be compared direct- COSTS of a project. For a formal ly with one another. mathematical definition, see the Nigeria appendix to chapter 9. Often abbrevi- Early-crop Maize Project in, 80-82, ated NPW Also called the "net present 83, 271, 276-77 value" (NPv). When using net present Smallholder Oil Palm Project in, 288 worth, the selection criterion is to Niswonger, C. Rollin, 190 accept all INDEPENDENT projects with N/K ratio. See NET BENEFIT-INVESTMENT a net present worth of zero or greater RATIO when discounted at a suitable Nominal. Stated as an amount of money DISCOUNT RATE, most often the Compare with REAL OPPORTUNITY COST OF CAPITAL. Gives Noncash operating expenses, 196 no ranking for order of implementa- Nontraded. A project INPUT or OUTPUT tion. When analyzing MUTUALLY that Is not TRADED across the national EXCLUSIVE alternatives, accept the boundaries of a particular country alternative with the greatest net pres- either because of its COST of produc- ent worth. Net present worth is the tion or because of restrictive trade preferred selection criterion for practices. Common examples are un- mutually exclusive alternatives. See skilled labor and land In PROJECT also PRESENT WORTH ANALYSIS, refers to goods and services additional purposes and choice of, not traded by the country in which 389, 390-91, 393 the project is located. In ECONOMIC aggregation method and, 291 ANALYSIS nontraded items are valued comparisons and ranking of, 358-61 at their MARGINAL VALUE PRODUCT If computing, 319-33, 358 they are INTERMEDIATE goods or ser- depreciation and, 351, 355 vices or according to the WILLINGNESS future prices and, 364 TO PAY criterion if they are FINAL incremental net benefit derivation goods or services. Distinguished from and, 317 TRADED. internal rate of return and, 331 Nontraded items mutually exclusive projects and, economic values determination 373-75, 377, 382, 383 and, 245 project selection and, 329, 350, 351 excess capacity and, 263 project worth as, 128 export and import parity values replacement costs and, 395 and, 269 residual value and, 397, 398 financial price adjustment and, switching value method and, 371-73 253-65 Netting-out, 345-46 In PROJECT ANALYSIS, foreign exchange premium and, the process of subtracting COSTS from 248, 250 BENEFITS to obtain the NET BENEFIT, labor value and, 258-63 or cash flow. When using the net ben- land value and, 256-58 efit as a basis for calculating a dis- market prices and, 253-56 counted cash flow MEASURE OF tradable but nontraded items and, PROJECT WORTH, it does not make any 263-65 drfference where in the process net- NPV. Net present value See NET PRESENT ting out occurs so long as there Is not WORTH any double counting. Thus, gross NPW. See NET PRESENT WORTH costs may be subtracted from gross Numeraire. The common measurement benefits, the project costs subtracted used as a unit of account. In PROJECT from the sum of the net benefits real- ANALYSIS, the unit that measures the ized on project farms, or any other objective being maximized. suitable formulation. This is a great economic and financial analysis convenience because data are likely to and, 244 reach the project analyst with costs Nutrition benefits, 280, 428 subtracted from benefits, or netted out, in different patterns. In contrast, Objectives, 418. See also National objec- when using the BENEFIT-COST RATIO tiveS the netting out must be done in ex- cost recovery, 223-24 GLOSSARY-INDEX 489 costs and benefits and, 45-46 normal activities of an enterprise. financial analysis and, 86-87 SELLING, GENERAL, AND plans and projects and, 6-7 ADMINISTRATIVE EXPENSES are usually project analysis and, 11 not included as an operating expense project preparation and social, 413 but are included as separate expenses Off-farm. In PROJECT ANALYSIS Or FARM in INCOME accounting. INVESTMENT ANALYSIS, not occurring Operating income before depreciation. on the farm that is the subject of the See FUNDS FROM OPERATIONS analysis, generally the farm of a Operating income (income statement), PROJECT beneficiary. Off-farm INCOME 196. Revenue less expense. Operating is the income earned by a farm family profit. from off-farm labor-employment Profit before INTEREST and TAXES. somewhere other than its own farm. Operating margin. The remainder after Off-farm work may include work on all expenses and TAXES are deducted other farms. from total sales. NET INCOME. Profit. Official exchange rate. The rate, estab- Operating profit, 196. INCOME (profit) be- lished by the monetary authorities of fore INTEREST and TAXES. See INCOME a country, at which domestic cur- Operating ratio, 203-06. OPERATING rency may be exchanged for foreign EXPENSES divided by revenue. A currency. Where there are no currency FINANCIAL RATIO used to judge controls, the official exchange rate is efficiency. taken to be the market rate. The of- Operation and maintenance. Refers to ficial exchange rate would always be the routine COSTS of PROJECT imple- used in FINANCIAL ANALYSIS. If more mentation. Often abbreviated as o&m. than one official exchange rate exists, Some agencies prefer operation, then the rate or rates that apply maintenance, and replacement, which should be used in financial analysis. is often abbreviated as OM&R. See FOREIGN EXCHANGE PREMIUM. Operation and maintenance charge (cost Olivares, Jose, 30 recovery), 228 O&M. See OPERATION AND MAINTENANCE Operation and maintenance cost (sepa- OM&R. Operation, maintenance, and re- rable costs-remaining benefits placement. See OPERATION AND method), 234-35, 239, 240 MAINTENANCE Opportunity cost. The BENEFIT forgone by OMVS. Organisation pour la MIs en using a scarce resource for one pur- Valeur du Fleuve Senegal. See Sene- pose instead of for its next best gal River Development Program alternative use. For example, suppose On-farm. In PROJECT ANALYSIS or FARM a farmer produces both rice and INVESTMENT ANALYSIS, occurring on maize but applies all his available fer- the farm that is the subject of analy- tilizer to rice. If instead he transferred sis, generally the farm of a PROJECT some of the fertilizer to his maize, he beneficiary. On-farm INVESTMENT Is would reduce the value of his rice the project investment that occurs on production somewhat, but he might the farms of project beneficiaries; an gain a much higher value of in- on-farm PRODUCTION EXPENSE is a creased maize production. The value project-related cost that occurs on the of his rice productton forgone would beneficiaries' farms. be the opportunity cost of the fertil- On the margin. See MARGINAL ANALYSIS izer used for maize production. In Operating entities, 191 this example, therefore, the opportun- Operating expenditure ity cost is the MARGINAL VALUE accounting convention and, 98-99 PRODUCT of the fertilizer in its next cash (income statement), 195-96 best alternative use. In a perfectly cash (incremental net benefit before competitive market where there are financing calculation), 212 many buyers and sellers, all of whom contingency allowances and, 394 have perfect information, the MARKET farm budget and, 133 PRICE will equal the marginal value farm inputs and, 123-26, 127 product of an item and thus market noncash (income statement), 196 price, opportunity cost, and marginal unit activity budget and, 143 value product will all be equal. In an) Operating expense. The expense, other enterprise, NET BENEFIT, or profit, will than financing, of carrying on the be maximized when the use of an 49(0 GLOSSARY-INDEX Opportunity cost (continued) using CAPITAL in the project. In prac- INPUT is adjusted to the point where tice, usually a weighted average cal- its marginal value product is equal to culation of the COST of securing proj- its opportunity cost. In project eva- ect capital from various sources In luation, for the FINANCIAL ANALYSIS the FINANCIAL ANALYSIS, the weighted aver- opportunity cost of a purchased input age cost to the firm or farm of EQUITY is always its market price. In capital and of borrowed capital from ECONOMIC ANALYSIS, however, the likely sources. In ECONOMIC ANALYSIS, opportunity cost of a purchased input usually the weighted average cost of is always either its marginal value capital to the economy as a whole, product in its best nonproject alterna- but sometimes the weighted average tive use, if for INTERMEDIATE goods cost of capital to the public sector. and services, or its VALUE IN USE (as The rate at which benefits and costs measured by WILLINGNESS TO PAY), if it are discounted in calculating the NET is a FINAL good or service. Since price PRESENT WORTH, the NET BENEFIT- is equal to marginal value product in INVESTMENT RATIO, or the BENEFIT- a perfectly competitive market, in an COST RATIO The CUT-OFF RATE for economic analysis if an input is PROJECT ANALYSIS, and hence the purchased in a reasonably competi- minimum acceptable INTERNAL RATE tive market the price is at least an ini- OF RETURN. Several methods exist for tial estimate of the marginal value formulating and for calculating the product of the input and, hence, of its economic opportunity cost of capital. opportunity cost. However, if because Difficulty in calculating the opportu- of market Imperfections or other nity cost of capital is a primary reasons the market price of an input reason for widespread use of the in- does not closely approximate the mar- ternal rate of return as a MEASURE OF ginal value product in its next best PROJECT WORTH. alternative nonproject use, the mar- cut-off rate and, 314 ginal value product is estimated discount measures and, 314, 333, directly, and that estimate becomes 346, 359 the SHADOW PRICE of the item. The internal rate of return and, 332 concept of opportunity cost is a cor- mutually exclusive projects and, nerstone of PROJECT ANALYSIS and is 382, 383 the central concept underlying valua- 382 383 tion of project inputs. See also net benefit-investment ratio and, 346 tronetfpresenttworthts.thod and, OPPORTUNITY COST OF CAPITAL economic values and, 243, 245 382, 383 family labor and, 139 Tunisian forestry project example farm-gate price calculation of market and, 387 prices and, 71 Optimization of project investment, 349 foreign exchange premium and, 250 Organizational aspects of projects, 14 operating expenditure (family labor or farmers and, 31 land) and, 126 project preparation and, 422-24 prices as reflection of value and, Outflow. All payments that are made, or 68-69 goods and services of value that are secondary costs and benefits analysis consumed or transferred, to other en- and, 60 tities and that decrease NET BENEFIT tradable but nontraded items Distinguished from INFLOW. and, 264 Output. A good or service produced by an unit activity budget problems and, activity. In PROJECT ANALYSIS, the 142, 143, 146 product of the PROJECT. valuing labor and, 258, 260, 262 aggregation and, 293 Opportunity cost of capital. The commercial aspects of projects OPPORTUNITY COST of using and, 16 INVESTMENT resources in a PROJECT loss avoidance and, 59 rather than in their next best alterna- market price as estimate of economic tive use; usually expressed in the form value and, 255 of an INTEREST rate. The reduction in predicting future prices and, 75 nonproject BENEFITS in relation to with and without comparisons and, project objectives that is a result of 47-50 GLOSSARY-INDEX 491 Overrun. Exceeding the COSTS estimated Partial payment factor. See CAPITAL or budgeted. RECOVERY FACTOR Owners' equity. See Equity, owners' Participants. See Project participants Oxen. See Work oxen Pasture, 115 carrying capacity and, 164, 174, 175 Pakistan feed budget and, 185 Canal Lining Project in, 48-49 improving, 165 Indus Basin Development Project labor use analysis and, 102 in, 10 operating expenditure and, 123-26 tradable but nontraded items example projected farm production and, and, 265 112, 113 Paraguay Livestock and Agricultural De- stable herd determination and, 178 velopment Project, 143, 159 Pattern farm plan. A model or prototype construction and, 119 of a "typical" FARM BUDGET that equal installment repayment example forms a basis for aggregating COSTS and, 153-56 and BENEFITS in an agricultural farm budget preparation and, 127-40 PROJECT and for making judgments farm-gate prices and, 118 about such other aspects of the proj- farm investment analysis example ect as the incentive effect for farmers, and, 94 feasibility, rate of acceptance, and herd projection and, 116 LIQUIDITY. herd projection example and, 163-87 Pattern farms. See also Farms incremental working capital and, aggregation methods and, 287-89 123-26 farm budgets and, 90, 93-94 investment and, 119-23 farm investment analysis and, labor use example and, 102-11 85-86, 89 land use example and, 99-101 Payback period, 302. An undiscounted operating expenditure and, 123-26 MEASURE OF PROJECT WORTH. The time valuation and, 117 from the beginning of a PROJECT until Parity. In PROJECT ANALYSIS, a parity the net (undiscounted) value of the PRICE or parity ECONOMIC VALUE is the incremental production STREAM totals price or value of a project INPUT that the amount of the (undiscounted) is based on a BORDER PRICE adjusted INVESTMENT Of CAPITAL. for expenses between the border and Payment the PROJECT BOUNDARY. aggregation and labor, 294, 296 Partial analysis. An analysis that labor and, 262-63 assumes that only certain elements Performance audits, 26-27, 29-30 analyzed will change while all others Perrins, R. E. G., 190 remain the same. Formally, ECONOMIC Personnel, 33 ANALYSIS is a partial analysis because Phasing of project (project preparation), only the elements of the PROJECT are 419-20 assumed to change while the overall Philippines economic setting remains unchanged. Crop Response to Nitrogen Fertilizer When this formal assumption must Project in, 65-69 be relaxed (for instance, when a proj- Ilocos Irrigation Systems Improve- ect will itself have an effect on exter- ment Project in, 319, 327, 328, 331, nal financial PRICES, or ECONOMIC 332, 343, 347, 401 VALUES), then conceptual problems Physical contingencies, 53-54, 395. See arise about the validity of the also CONTINGENCY ALLOWANCES analysis. Physical goods costs, 52-53 Partial budget. A budget that addresses Pigs, 113, 163, 185 itself to only part of an enterprise. Planning, 22, 23 Compares the MARGINAL COST (includ- economic growth and, 6-7 ing OPPORTUNITY COST) ofan activity financial analysis and, 87 within an enterprise with the mar- project format and, 8 ginal increase in BENEFIT that the water resources booklet for, 345 new activity will bring. Distinguished Point of first sale, 70-71. The location from WHOLE FARM BUDGET. See also where the first sale transaction takes UNIT ACTIVITY BUDGET place for a product. If the point of techniques for, 91, 141 first sale is in a relatively competitive 492 GLOSSARY-INDEX Point of first sale (continued the future. Its use is direct and simple market, the PRICE may be a good esti- if it is used for a constant STREAM Of mate of ECONOMIC VALUE. By using a money that begins in the first year price derived from the point of first and lasts to some future year, say 11, sale, the analyst avoids using an of a PROJECT. It may also be used to IMPUTED value determine the present worth today of Policy a constant stream of money that be- changes in trade, 271-78 gins some time other than the first project success and price, 34-35 year, say in the 7th year of a project Political environment, projects and, 11 and continuing through the 15th Pollution, 16 year, although this takes some addi- Population, project preparation and, tional manipulation. See appendix B, 416-17 and the subheading "Present worth of Population projects, 280 a stream of future income" in chapter Pouliquen, Louis Y., 371 9, see also TIME VALUE OF MONEY Poultry, 113, 163, 185 Present worth factor. See DISCOUNT Poverty, project preparation and, FACTOR 413-14 Present worth of 1. See DISCOUNT FACTOR Power benefit, 234 Present worth of 1 per annum. See Powers, Terry A., 183 PRESENT WORTH OF AN ANNUITY FACTOR Preparation. See Project preparation Present worth of a stream of future in- Present worth. (1) The value at present of come. The PRESENT WORTH (at time an amount to be received or paid at to) of a STREAM Of INCOME commenc- some time in the future. Determined ing sometime in the future (that is by multiplying the future value by the other than at time t1). When the DISCOUNT FACTOR, which is I - (1 + stream of future income consists of i)n where i = the DISCOUNT (INTEREST) the same amount paid or received RATE and n = the number of years. each ACCOUNTING PERIOD, the present In practice, the discount factor is worth may be determined by subtract- obtained from a set of compounding ing the PRESENT WORTH OF AN ANNUITY and discounting tables. (2) The sum FACTOR, for the number of years before of the present worths of a series of fu- the stream begins for the appropriate ture values. See also NET PRESENT INTEREST rate, from the present worth WORTH of an annuity factor for the last year benefit-cost ratio and, 345 of the stream and by multiplying the of capital cost (cost recovery resulting factor by the amount paid index) 226 or received each accounting period. discounting, 308-09, 356 The future income stream is some- domestic resource cost and, 400 times called a "lagged annuity," and future income stream and, 309-13 the factor derived from the present net benefit-investment ratio and, worth of an annuity factor may be 347-49 called the "lagged annuity factor." residual value and, 398 Prest, A. R., 59, 300 separable costs-remaining benefits Price. The amount (usually of money) method and, 235-36, 237 that must be exchanged for a good or Present worth of an annuity factor How a service. In general in this book, much 1 received or paid annually is price refers to a MARKET PRICE, or a worth today. Also called the "present financial price discussed as part of worth of I per annum" and the "dis- FINANCIAL ANALYSIS, as distinguished count factor for a stream of income." from an ECONOMIC VALUE, which is The expression [(1 + i)" - 1] - [i(l used for amounts discussed in con- + i)n] where i = the rate of INTEREST nection with ECONOMIC ANALYSIS. See and n = the number of years. The re- ECONOMIC VALUE, MARKET PRICE; ciprocal of the CAPITAL RECOVERY PARITY; Prices; SHADOW PRICE FACTOR. Generally obtained from a set Price contingencies, 53-54, 393-94, 395. of compounding and discounting See also CONTINGENCY ALLOWANCES tables. This factor enables determina- Price index. See INDEX NUMBER tion of the PRESENT WORTH of a Price Prospects for Major Primary Com- CONSTANT amount received or paid modities (World Bank 1982), 76, each year for some length of time in 77, 217 GLOSSARY-INDEX 493 Prices EFFICIENCY PRICE; MARKET PRICE; contingency allowances and, SHADOW PRICE 393-94, 395 Principal. The amount of a loan. declining real burden and, 158-59 capitalized interest and, 157-58 efficiency ratio and, 206 computing debt service and, 147 electricity, 267 declining real burden of debt service finding market, 69-74 and, 158, 161-62 implementation of project and equal installment repayment and, 156 changes in, 24 foreign exchange flow and, 222 information on international, 77-78 government cash flow and, 219 for internationally traded commod- repayment, 202 ities, 77-78 repayment of equal amounts and, predicting future, 74-77 150-53 project analysis success and, 34-35 Private enterprises, 17, 18, 21 project format limitations and, 10, 11 debt financing and, 207 as reflection of value, 65-69 debt repayment and, 87 sensitivity analysis and, 364 financial assessment and, 86 valuing land and, 257 objectives and, 44 water charges (cost recovery) and, "Procedures for Evaluation of National 223-24, 225 Economic Development Benefits Price system. The system by which the and Costs in Water Resources Plan- amounts and qualities of goods and ning" (U.S. Government 1979), 345 services are determined (and, hence, Proceeds per unit of outlay, 302. An un- resources to produce them allocated) discounted MEASURE OF PROJECT by the PRICE that consumers are will- WORTH. The total net (undiscounted) ing to pay. In a price system in value of incremental production di- which markets are permitted to work vided by the total (undiscounted) without outside intervention, the amount of the INVESTMENT. price system will tend toward an Processing industries optimal allocation of resources and of aggregation and, 289 production of goods and services: if balance sheet statement and, 190, there is a shortage of an item the 192-95 price will rise, and new resources will creditworthiness ratios and, 207-09 be applied to its production, until a efficiency ratios and, 203-06 new equilibrium is achieved in which financial analysis overview of, 189-92 no other combination of goods and financial rate of return measure and, services produced or allocation of re- 209-12 sources could produce greater satis- financial ratios and, 202-09 faction. In practice, no price system income ratios and, 206-07 achieves this ideal. In all markets income statement and, 190, 194, there are frictions caused by lags in 195-96 response. Certain public services that project benefits and, 58 are not easy to sell through the mar- project preparation and, 419, 426 ket cannot readily be incorporated in sources-and-uses-of-funds statement the price system. For historical and, 197-202 reasons, some individuals or groups Procurement may have a (MONOPOLISTIc) control equipment and, 16 over ASSETS that permits them to project preparation and, 422 manipulate the price system to their Procurement procedures, 16 own advantage. Finally, a consumer's delays in, 33 ability to buy and sell depends on his Producer prices, importance of, 34-35 INCOME, which may not reflect the Production, 4, 5, 206 society's view about the consumption aggregation method and farm, 291 desirable for that person. For reasons crops and pasture and, 112 such as these, all societies direct the discounting assumptions and, 99 price system to a greater or lesser de- farm budget and, 132 gree so that it can better serve the incremental residual value and, particular society's purpose; such 117-19, 121 efforts constitute the substance of livestock and, 112-17, 183, 185-86 price policy. See also DISTORTION; project benefits and, 56-57 494 GLOSSARY-INDLX Production (continued) calculators and, 401-08 projected farm (farm investment computer use and, 408 analysis), 111-19 contingency allowances and, 394-95 project preparation and, 425 design and implementation problems rent recovery computation and, with, 29-35 229, 231 discounting convention for, 315 unit activity budget and, 143 discount measure selection and, 359 valuation and, 117, 120 economic aspects of, 18-21 with and without comparisons and, farm budget aggregation and, 289 47-49 financial aspects of, 16-18 Production expense. A cOsT, incurred to government receipts and expenditures produce project OUTPUT, that is recov- and, 215-17 ered as soon as the output is sold or incremental net benefit and, 318 consumed. Variable cost. Examples institutional aspects of, 13-14 include wages and fertilizer internal rate of return and, 341 Profit. See also INCOME managerial aspects of, 14-15 before taxes (income statement), 197 organizational aspects of, 14 government cost flow and, 219 partial, 10 gross, 195 planning and, 6-7 operating (income statement), 196 problems with poor, 35-37 Program. An ongoing development effort programs and, 4-5 or plan. Distinguished from a project format and, 8, 9 PROJECT, which has a specific objec- project sequence (cycle) and, 22-24 tive, activity, begtnning, and end, social aspects of, 15-16 May include various projects at vart- switching value method and, 371 ous times as its constituent units technical aspects of, 12-13 Program analysis, 4-5 trade policy changes and, 271-78 Programming model, 10 unit activity budget approach to, 141 Project. In this book, generally refers to Project boundary. The extent of the actw- an INVESTMENT aCtivity upon which ities included within PROJECT resources-coSTS--are expended to accounts. Derives from the concept of create capital ASSETS that will produce the physical boundaries of a project, BENEFITS over an extended period of but is extended to allow for projects time and which logically lends itself that do not have fixed geographical to planning, financing, and im- boundaries but rather may have a plementing as a unit. A specific activ- combination of-participants in van- ity, with specific starting point and ous geographic locations. specific ending point, intended to Project boundary price accomplish a specific objective. The economic import parity value smallest operational element prepared and, 270 and implemented as a separate entity export and import parity prices in a national plan or PROGRAM. and, 78 Generally unique in that it is not a market price determination and, 74 segment of an ongoing program, Project cycle. The sequence of analytical although it may be a "time slice"-a phases through which a PROJECT portion lasting several years-of a passes. In this book taken to be: iden- LONG-TERM program. May produce tification, preparation and analysis, BENEFITS that can be valued in MONEY APPRAISAL, Implementation, and evalu- TERMS or benefits that are INTANGIBLE. ation. (See Baum 1978.) Many varia- See Projects tions of this particular division of the Project analysis. An analytical system project cycle have been proposed. See that compares COSTS with BENEFITS to PROJECTS, sequence (cycle) of determine if a proposed PROJECT, Project delays given the alternatives, will advance in implementation, 28-29, 36 the objective of the entity from whose procurement problems and, 33 standpoint the analysis is being sensitivity analysis and, 364, 369-71 undertaken sufficiently to justify Project design, problems with, 29-35 undertaking the project. Project format, 5. An analytical accuracy of, 26-29 framework, for a proposed analytical techniques and, 10-12 INVESTMENT, in which the COST and CLOYSARY-INDLX 495 BENEFIT accounts are prepared in the debt-equity ratio and, 208 form of a PROJECT. debt repayment and, 87 advantages of, 7-9 financial assessment and, 86 limitations of, 9-12 income ratios and, 207 Project implementation. See Imple- objectives and, 44 mentation Purchases (herd), 112, 114, 116, 117 Project life accounting convention and, 164, 165 accuracy of analysis and, 27 farm investment and, 123 discount factors and, 355-56, 357 feed budget and, 187 farm investment analysis and, 90 herd growth and, 183 implementation of projects and, 25 herd projection and, 163 investment funds movement (sources- and-uses-of-funds statement) and, 198 Quality separable costs-remaining benefits improvements, 57, 428 method and, 235 prices and, 73 Project model (aggregation example), Questionnaire (farm investment analy- 291-96 sis), 92-93 Project objectives. See Objectives Quotas, 263, 276, 277, 278. In reference Project participants, 5. See also Farmers; to foreign trade policy, a quota is a Government agencies; Private enter- limitation on the quantity of an item prises; Public enterprises that may be imported aggregation methods and, 289 farm investment analysis and, 90 financial aspects of projects and, Rahad Irrigation Project (Sudan), 74 17, 86 export parity price example and, financial planning and, 87 78-80, 271, 272-75 financing of projects and, 129 Rajasthan Smallholder Dairy Improve- project preparation and, 424 ment Project (India), 57 Project preparation Ranking, 352-53 design and analysis of, 12-21 application of, 350-51 guidelines for report on, 411-28 benefit-cost ratio and, 346 implementation delays and, 29 comparisons and criteria for, 358-61 importance of, 3 by inspection, 300-01 institutional assistance for, 437-43 net benefit-investment ratio and, poor project analysis and, 35-36 346-47, 349 sequence of projects and, 22-24 net present worth and, 329 steps in project analysis and, 37 undiscounted project worth measures Projects. See also Multipurpose projects; and, 301-04 Mutually exclusive projects; Single Ranking by inspection. An undiscounted purpose projects MEASURE OF PROJECT WORTH that defined, 4-6 simply consists ofexamining the expansion and, 191 INVESTMENT Cost O a PROJECT and the identifying, 21-22 shape of the net value of incremental market price as estimate of economic production STREAM. In general, there value and, 255 are two instances when ranking by phasing of, 419-20 inspection may be used: (1) when, ranking of, 300-04, 329, 346, 346-47, with the same investment, two proj- 349, 350-51, 352-53 ects produce the same net value of in- selecting among alternative (dis- cremental production for a period but counted measures), 350-51 one continues to earn longer than the sequence (cycle) of, 21-26 other; and (2) when, for the same in- small vs. large, 377 vestment, the total net value of in- testing, 9-10 cremental production of two projects water development (joint cost alloca- is the same but one project has more tion), 233 of the flow coming earlier in the time Project selection. See also Ranking sequence. alternative, 350-51 Rate of acceptance. The rate at which costs and returns values and, 6 farmers adopt new techniques or Public enterprises, 17, 198 technology. 496 GLOSSARY-INDEX Rate of return. Remuneration to is implemented. Usually refers to INVESTMENT stated as a proportion or costs borne by the government budget. percentage. Often the INTERNAL RATE Some governments have separate re- OF RETURN. The FINANCIAL RATE OF current and CAPITAL budgets from RETURN is the internal rate of return which project costs are financed. based on MARKET PRICES; the Regionality, social aspects of projects ECONOMIC RATE OF RETURN is the in- and, 15 ternal rate of return based on Relative prices. See also INFLATION ECONOMIC VALUES. See also ECONOMIC declining real burden and, 158 RATE OF RETURN; FINANCIAL RATE OF predicting future prices and, 75-76 RETURN; INTERNAL RATE OF RETURN Rent A fixed periodic payment made by a discount measures and, 357-58 user to an owner for the possession efficient resource use and, 86 and use of property. Compare with financial rate of return and, 210 ECONOMIC RENT income ratios and, 206 unit activity budget calculations project analysis accuracy and, 27-28 and, 143 residual value and, 397, 398 valuing land and, 257 sunk costs and, 55 Rental value of farm house Ratio analysis See FINANCIAL RATIO farm budget calculations and, 132-33 Real. Reflects the physical, not NOMINAL market price determination and, 74 or relative, quantities of goods or Rent recovery (measuring), 228-32 amounts ofservrces. A financial PRICE Rent recovery index The proportion of or ECONOMIC VALUE quoted in real the ECONOMIC RENT created by a PROJ- terms refers to the same physical ECT that accrues to project beneficia- quantity of goods or actual amount ries and is recovered from them. In of services whenever it appears in a an irrigation project, equals [(in- series. A financial PRICE Or ECONOMIC cremental revenue from water sales + VALUE quoted in MONEY (or nominal) Incremental BENEFIT TAXES) - In- TERMS refers to the monetary prices of cremental economic rent accruing to goods and services and, because of project beneficiaries], stated in per- the effect of general price INFLATION, centage terms. Calculated in may vary at different times even CONSTANT, MARKET PRICES, generally though it refers to the same quantity for a year after the project has of goods and services. reached FULL DEVELOPMENT Real burden of debt service. The pro- Repayment portionate DEBT SERVICE burden rela- computing debt service and, 147 tive to all other PRICES paid by the of equal amounts of principal, 150-53 borrower. In FARM INCOME ANALYSIS, government cash flow (principal) and, the FARM BUDGET most often is calcu- 219, 220 lated assuming that debt service will of loans (sources-and-uses-of-funds be CONSTANT in REAL terms. Yet in statement), 199, 202 most countries lending terms to far- money terms and, 158 mers call for repayment in NOMINAL project preparation and, 423 Or MONEY TERMS. INTEREST is stated at Replacement costs. See Costs, replace- a given rate and the nominal amount ment of PRINCIPAL repayment is agreed Resale value. See RESIDUAL VALUE upon. Under conditions of INFLATION Research, 31 that would reduce the real value of project preparation and, 424 money over time, the result would be Reservation price The minimuni PRICE that farmers would have a declining at which an individual is willing to real burden of debt service over the offer a good or service. Often applied life of the loan To avoid this out- to labor, it is the lowest wage at come, a loan may be indexed to some which an individual is willing to offer appropriate price index so that the his or her services. real burden remains the same during for leisure, 139 the life of the loan. Reserves (retained earnings), 195 declining assumptions and, 158-62 Residual asset. See RESIDUAL VALUE Reconciliation accounts, 197 Residual value. The value of an ASSET re- Recurrent. Occurring repeatedly. Recur- maining unused at the end of a rent COSTS of a PROJECT are those PROJECT. Also called "terminal value." which occur repeatedly as the project The asset itself may be called a "re- GLOSSARY-INDEX 497 sidual asset." In PROJECT ANALYSIS, turned by the cash flow, but there is the residual value is generally added no return to capital. to the BENEFIT STREAM in the last year farm income analysis and, 89 of the project. It is often taken to be Return on equity. (1) the INTERNAL RATE the "resale value" of an asset that is OF RETURN of the incremental NET used and then put up for sale. "Sal- BENEFIT after financing. Used as a vage value" is a form of residual MEASURE OF PROJECT WORTH. (2) Net value that refers to an asset that at INCOME divided by EQUITY. A the end of the project has value only FINANCIAL RATIO used to judge return as scrap. WORKING CAPITAL is treated to critical aggregates. as a residual value credited to the Return on sales. Net INCOME divided by project in the final year of the revenue. A FINANCIAL RATIO used to analysis. judge return to critical aggregates. projected farm production and, Reutlinger, Shlomo, 371 117-19, 121 Revenue, 206 resale value of fixed assets as, 196 income statement and, 195, 196 Resources incremental net benefit before financ- aggregation and flow of, 293 ing calculations and, 212 cost of domestic, 398-400 project preparation and tax, 421 efficient use of (judgment), 86 Riley, J. Paul, 234, 235, 240 farm budget calculations and, 128 Ripman, Hugh, B., 12 farmer's own (use of), 129, 140 Risk financial rate of return to all, 209, analysis of, 9-10, 371 210-12 creditworthiness ratios and, 207 labor use and, 102-11 cropping patterns and, 91 land use and, 99-101 rent recovery and, 231 project preparation and, 415 technology and, 30 real costs and benefits of (tradable but Risk analysis. An analytical technique in nontraded items), 263 which probabilities of occurrence are unit activity budgets and, 142 determined for all critical PROJECT ele- Retained earnings, 195. In U.S. account- ments and then, by computer, re- ing terminology, the portion of net peated computations of a MEASURE OF INCOME, or profit, that is kept and PROJECT WORTH are made, each ele- reinvested within an enterprise rather ment entering in successive computa- than distributed as DIVIDENDS to tions according to its probability of shareholders. In British accounting occurrence. The result is most com- terminology, called "reserves." monly reported in the form of a cumulative probability curve plotted Return on assets. OPERATING INCOME di- on a graph in which the vertical axis vided by ASSETS. A FINANCIAL RATIO represents the probability a measure that is used to judge return to critical of project worth will fall below a aggregates. stated value and the horizontal axis Return of capital. The return to the inves- represents the values of the measure tor of part or all of the initial of project worth. Sometimes called INVESTMENT O CAPITAL in a PROJECT. "probability analysis." Compare with The incremental NET BENEFIT, or in- SENSITIVITY ANALYSIS. See Reutlinger cremental cash flow, is an undiffer- (1970) and Pouliquen (1970). entiated STREAM of amounts consist- River basin development projects, 388, ing of the return of capital and the 389-93 RETURN TO CAPITAL. Road projects, 382-83 Return to capital. The RATE OF RETURN Rural development, 15 received by the investor on CAPITAL new technology and, 30 engaged in a PROJECT. The in- Rural development projects, 281-84, 388 cremental NET BENEFIT, or in- Rural Infrastructure Project (Korea), cremental cash flow, is an undiffer- 281-84 entiated STREAM of values consisting Rural poor, effect of projects on income of the return to capital and the of, 28 RETURN OF CAPITAL. The INTERNAL RATE OF RETURN is a measure of the return to capital. When the internal Sales (herd), 112, 114, 116, 117 rate of return is zero, all capital is re- accounting convention and, 164, 165 498 GLOSSARY-INDEX farm budget and, 133 Selection. See Project selection farm investment and, 123 Selling, general, and administrative ex- feed budget and, 187 pense. A section on an INCOME herd growth and, 183 STATEMENT that combines certain herd projection and, 163 overhead expenses connected with Sales (rent recovery computation), 229 marketing costs and administration Sales (return on), 206-07 of the enterprise. Compare with Salvage value. See also RESIDUAL VALUE OPERATING EXPENSE of capital assets, 118 income statement and, 196 measure of project worth calculations incremental net benefit before financ- and, 398 ing calculations and, 212 Sanitation projects, 280 Senegal River Development Program, Saving 233-40 cost recovery and public, 224 Sensitivity analysis. An analytical tech- economic values determination ntque to test systematically what hap- and, 246 pens to the earning capacity of a Savings weight. The relative importance PROJECT if events differ from the estt- attached to the use of BENEFIT from a mates made about them in planning. PROJECT for saving as opposed to con- A means of dealing with uncertainty sumption. In general, saving is con- about future events and values. A sen- sidered the more valuable objective. sitivity analysis is done by varying The amount of the benefit that will be one element or a combination of ele- saved is weighted by the savings ments and determining the effect of weight so that the final MEASURE OF that change on the outcome, most PROJECT WORTH will favor those proJ- often on the MEASURE OF PROJECT ects that lead to greater saving. See WORTH. In agricultural PROJECT Squire and van der Tak (1975) Coin- ANALYSIS, most projects should be pare with DISTRIBUTION WEIGHT tested at least for the effects on earn- Schaefer-Kehnert, Walter, 95, 140, 163 ing capacity of changes in PRICES, Schistosomiasis, 15 COSL OVRUN, delay in implementa- Schwab, Gerald D., 90 tton, and changes in YIELD. SensItiv- Sea Defense Project (Guyana), 47-48 ity tests neeg -be directed at the Seasonality effect ofa change on a measure of market price determination and, 73 project worth. A sensitivity test may project preparation and, 417 be nade, for example, to determine valuing labor and, 258, 261-62 the effect of a delay In BENEFITS On Secondary. With reference to cosTs and the cash position of a fanner who BENEFITS, a cost or benefit that arises has borrowed for an irrigation pump. outside the primary PROJECT accounts A variation of sensitivity analysis is as a result of the costs or benefits of to determine the SWITCHING VALUE. the project working through the Compare with RISK ANALYSIS MULTIPLIER effect. In PROJECT project analysis and projection and, ANALYSIS, systems that use VALUE IN 363-65 USE or OPPORTUNITY COST as the value switching value variation of, 371-73 criterion in ECONOMIC ANALYSIS (such technique of, 365-71 as the system in this book and most Separable costs-remaining benefits systems used by international agen- method, 233, 234-40. A method of cies), secondary costs do not exist be- allocating JOINT COSTS in a cause all costs and benefits in the MULTIPURPOSE PROJECT among van- project are adjusted to reflect their ous classes of beneficiaries. Each effect on NATIONAL INCOME. An allow- class of beneficiary is charged for all ance for secondary costs and benefits of any separable costs attributable to ts needed only if an estimate of eco- its use of the multipurpose project nomic effect is to be made using and then shares the joint costs in MARKET PRICES only, as in the system proportion to its remaining BENEFIT used in the United States for natural See the section on "Joint Cost Alloca- resources projects. See BENEFIT; COST; tion" in chapter 6. ASSOCIATED COST Services, project preparation and, 419 Sector survey, project identification Shadow exchange rate. See also SHADOW and, 22 PRICE GLOSSARY-IN )EX 499 foreign exchange premium and, joint cost allocation and, 233 248-49 secondary costs and benefits and, 60 indirectly traded items and, 266, sensitivity analysis and, 364 267, 269 Shadow wage rate. See SHADOW PRICE Shadow price. The value used in Share capital. CAPITAL invested in an en- ECONOMIC ANALYSIS for a COST or a terprise in return for a claim upon a BENEFIT in a PROJECT when the share of any future INCOME distrib- MARKET PRICE is felt to be a poor esti- uted as DIVIDENDS. mate of ECONOMIC VALUE. Generallv Sheep, 175 used as a synonym for "accounting Short-term. Occurring over a relatively price." Shadow price technically im- short period. Often taken to be one plies a PRICE that has been derived year or less. In economics, a period from a complex mathematical model too short to depreciate fully and re- (for example, from LINEAR place plant and equipment. Contrast PROGRAMMING), whereas an account- with LONG-TERM; MEDIUM-TERM ing price simply indicates that the Single purpose projects price is not a market price. In current costs and, 233 usage, this distinction has largely purposes in, 388, 389-90, 391, 393 been lost, and shadow price is gener- Sinking fund factor. The level deposit re- ally used for both purposes. In this quired each year to reach I by a given book, shadow prices are estimates of year. The expression i - [(1 + i)n - EFFICIENCY PRICES. For FINAL goods I] where i = the rate of INTEREST and and services, the shadow price is the n = the number of years. The recip- VALUE IN USE. For INTERMEDIATE rocal of the COMPOUNDING FACTOR FOR goods and services, the shadow price I PER ANNUM. Generally obtained is the OPPORTUNITY COST, the benefit from a set of compounding and dis- forgone by using a scarce resource for counting tables. This factor permits one purpose instead of its next best calculating the equal installment that alternative use. Opportunity cost, for must be set aside each year, to be in- intermediate goods and services is by vested at compound interest, in order definition equal to the MARGINAL to have a predetermined sum at a VALUE PRODUCT, the value of addi- given time. It is primarily used to de- tional OUTPUT generated by an addi- termine how much must be put into a tional unit of variable INPUT. The fund in order to have recovered the "shadow wage rate" is the shadow amount of an INVESTMENT at the end price for labor and is generally set by of its useful life. Note, however, that estimating the marginal value product this is a very mechanistic of labor. The "shadow exchange rate" DEPRECIATION rule and may not be is the shadow price of FOREIGN good management practice in many EXCHANGE and reflects the FOREIGN circumstances. See appendix B. EXCHANGE PREMIUM. The shadow ex- Smallholder Dairy Improvement Project change rate is the OFFICIAL EXCHANGE (India), 57 RATE multiplied by 1 plus the foreign Smallholder Oil Palm Project (Nigeria), exchange premium stated in decimal 288 form. When the CONVERSION FACTOR Smidt, Seymour, 300 approach is used to allow for trade Social aspects of projects, 15-16 distortions, the opportunity cost or failure to appreciate, 32 value in use is first multiplied by the project preparation report and, 413, conversion factor (often the standard 416-17, 419, 427-28 conversion factor) to obtain the Social time preference rate, 314. A rate, ECONOMIC VALUE used in the ECONOMIC usually expressed in the form of a per- ANALYSIS. See EFFICIENCY PRICE centage, that expresses the preference crossover discount rate example of a society as a whole for present re- and, 388 turns rather than future returns and defined, 243 that sometimes is proposed as a economic analysis and, 69 DISCOUNT RATE for PROJECT ANALYSIS. economic values and, 244, 245 Generally considered to be less than export and import parity prices the OPPORTUNITY COST OF CAPITAL, and, 78 which expresses a summation of indi- foreign exchange premium and, 248 vidual time preferences because the 500 GLOSSARY-INDEX Social time preference rate (continued) Stemming-from benefit. A form of in- society as a whole has a longer time direct BENEFIT that accrues to pur- horizon than does any one of its chasers of project OUTPUTS that are members. themselves INTERMEDIATE products. "Sources of Information on World The direct and indirect VALUE ADDED Prices" (Woo 1982), 78 generated in fonvard-linked indus- Sources-and-uses-of-funds analysis. See tries. For example, cotton that is pro- FUNDS FLOW ANALYSIS duced by an agricultural project and Sources-and-uses-of-funds statement, 89, that would be used in existing cotton 190, 196. A financial statement that gins having unused production measures the total flow of financial capacity might allow those gins to resources into and out of an enter- create additional value added that prise during an ACCOUNTING PERIOD would not exist without the project. Also called the "statement of changes Stemming-from benefits sometimes in financial position," "funds state- are calculated using specialized input- ment" or "funds flow statement," output MULTIPLIERS. Would not nor- "sources and applications of funds mally exist where project outputs are statement," "statement of change in TRADED, since the same stemming- WORKING CAPITAL," or, sometimes, from benefits could be had by increas- "cash flow" (not the same concept as ing imports of the intermediate prod- cash flow as meant when discounted uct or by diverting exports (see CASH FLOW ANALYSIS is intended). TRADED) to local use. A category of financial rate of return and, 211, 212 benefits normally identified in water preparation of, 198-202 resource programs in the United South Nyanza Sugar Project (Kenya) States. Numerous studies have indi- balance sheet example and, 192-95 cated that substantial potential exists financial ratio examples and, 202-09 for misusing concepts of stemming- financial statement example and, from benefit in PROJECT ANALYSIS. 190-92 Storage, 57-58 foreign exchange flow example and, project choice example and, 386 220-22 Straight-line depreciation. See government cash flow example and, DEPRECIATION 217-20 Stream. A series. A sequence of values ex- income statement example and, tending over several years that may 195-97 then be called a "time stream." The sources-and-uses-of-funds example particular variation in amount of a and, 197-202 stream from year to year may be re- Squire, Lyn, 20, 21, 60, 246, 247, 248, ferred to as its "pattern." 249, 254, 259, 267 Subsidies Stable herd. In HERD PROJECTIONS, a herd direct transfer payments and, 50, of animals that just maintains the 51-52 numbers in each class and generall' economic analysis and, 19 just consumes the feed available. farm budget calculations and, 132 Staffing, 33 financial price adjustment (transfer Standard conversion factor. See payments) and, 251 CONVERSION FACTOR income statement and, 197 Standard deviation. A measure of the incremental net benefit before financ- dispersion of a frequency distribution. ing calculations and, 212 Obtained by extracting the square indirectly traded items and export, root of the ARITHMETIC MEAN of the 267 squares of the deviation of each of sources-and-uses-of-funds statement the class frequencies from the arith- and, 199 metic mean of the frequency distribu- Subsidy A TRANSFER PAYMENT. A direct tion. subsidy is a payment made by a gov- Steers enment to a producer (such as a defined, 164 fanner) and is a direct transfer pay- feed budget and, 185 ment. An indirect subsidy may occur herd growth and, 179, 180, 181 when manipulation of the market stable herd determination and, 177, produces a PRICE other than that 178, 179 which would have been reached in a GLOSSARY-INDEX 501 perfectly competitive market. The sons or property for public purposes. BENEFIT received by a producer or A tax is a TRANSFER PAYMENT. A consumer as a result of thts difference "direct" tax is a tax that is difficult to constitutes an indirect transfer pay- shift to another person; examples in- ment. Indirect subsidies may be clude income taxes, inheritance taxes, transfers from other parties in the and poll taxes. An "indirect" tax is a society or from the government, tax that can fairly readily be shifted, Sudan, Rahad Irrigation Project in, 74, or the burden passed on, to someone 78-80, 271, 272-75 else by the taxpayer; examples include Sunk cost, 55. A COST incurred in the past sales taxes and import duties, which that cannot be retrieved as a RESIDUAL are generally added to the sale price of VALUE from an earlier INVESTMENT. A a good. See TRANSFER PAYMENT sunk cost is not an OPPORTUNITY COST Taxes and thus is not included among the cost recovery example and, 224, costs when a proposed PROJECT or 225-26 other investment is analyzed; only fu- cost recovery index and, 228 ture return to future cost is consid- debt service ratio on before-tax basis ered. In economics, sunk cost is and, 209 equivalent to fixed cost in SHORT-TERM direct transfer payments and, 50, decisionmaking. 51, 52 Suppliers' credit. Term loans offered by a economic analysis and, 19, 317 seller for the purchase of his goods or export, 216 services. farm budget and, 133 Support systems financial price adjustment (transfer poor project analysis and, 31-32 payments) and, 251 project preparation and, 419 financial rate of return and, 209, 212 Survival rate. With reference to livestock, government cash flow and, 219 the proportion of animals at the be- income, 133, 197, 201, 212, 318 ginning of a time period that live to income statement and, 197 the end of the period; 1 less the indirect (incremental net benefit be- MORTALITY RATE expressed in decimal fore financing calculations), 211 form. Generally expressed as a per- payable (but not yet paid), 195 centage. project costs and, 54 Switching value. The value an element of rent recovery and, 231, 232 a PROJECT would have to reach as a Taylor, Lance, 248 result of a change in an unfavorable Technical analysis, 12-13 direction before the project no longer Technical change, project implementa- meets the minimum level of accept- tion and, 24 ability as tndicated by one of the Technical coefficients measures of PROJECT WORTH. See adult mortality, 166 SENSITIVITY ANALYSIS animal units, 174-75 Switching value method (sensitivity calf mortality, 166 analysis variation), 371-73 calving rate, 166 Sykes, Allen, 300, 341 culling rates, 166-67 Syria, First Livestock Development Proj- herd growth, 179-83 ect in, 47 herd projections and, 113, 115-16, 117, 163, 165-83 Tangible. In project analysis, a COST or ratio of bulls to breeding females, BENEFIT that is capable of being 167-74 appraised at an actual or approxi- stable herd determination and, 175-79 mate PRICE Or ECONOMIC VALUE. Dis- Technology tinguished from INTANGIBLE. See also farm investment analysis and, 91, 92, REAL 93-94 Tariff, 277. (1) A DUTY or TAX imposed on implementation and inappropriate, an import or export. (2) A schedule of 30-31 charges of a business, especially of a mutually exclusive projects and, public utility. 383-88 Taste preference, farmers and, 44 new, 30, 31 Tax. A charge, usually money, imposed by obsolescence in, 9 a governmental authority upon per- secondary costs and benefits and, 61 502 CLOSSAR1-INDEX Tenant farmers, 15 tion ivill affect a country's level of im- Tenure, project preparation and, 416 ports or exports on the margin (see Terminal value. See RESIDUAL VALUE MARGINAL ANALYSIS). In ECONOMIC Third Agricultural Credit Project ANALYSIS, the value of traded items is (Kenya), 140-41, 147-50 based on their BORDER PRICE. IMPORTS Third Highway Loan Project (Kenya), and IMPORT SUBSTITUTES are valued at 382-83 the import PARITY price, which is the Time-adjusted Refers to an accounting C.I.F. value adjusted for domestic convention in which the first year of costs between the PROJECT and the an investment analysis is used solely point of entry. Exports and DIVERTED for INVESTMENT and in which In- EXPORTS are valued at the F.O.B. value cremental BENEFITS appear only from adjusted for domestic costs between year 2 or later (Schaefer-Kehnert the project and the point of export. 1978). Used for FARM INVESTMENT Traded goods ANALYSIS to make the analysis con- export and import parity values gruent with the assumption of and, 269 DISCOUNTED CASH FLOW ANALYSIS. financial price adjustment and, Time-adjusted accounting convention. 251-53 See Accounting convention (time- foreign exchange premium and, adjusted) 247-48, 249-50 Time adjustment, benefits and, 57 Trade policy changes, economic values Time overruns (project), 27, 28-29 determination and, 271-78 Time-slice. See PROJECT Transfer payment. A payment made with- Time value of money. An expression re- out receiving any good or service in ferring to the concept that values re- return (except, perhaps, the service in- ceived earlier are worth more than volved in making the transfer pay- values received later. The concept ment). A "direct" transfer payment underlying DISCOUNTING. occurs when a payment is made that discounted measures of project worth directly shifts claims to goods and and, 313 services from one entity to another discounting convention for project entity in the society. In agricultural analysis and, 315 PROJECTS, the most common direct discounting present worth and, transfer payments are TAXES and 308-09 direct SUBSIDIES Other examples are discount rate choice and, 313-15 charitable contributions and welfare income stream and, 309-13 payments In PROJECT ANALYSIS, loans interest computations and, 305-08 and DEBT SERVICE-payment of mutually exclusive project example INTEREST and repayment of and, 387 PRINCIPAL-are treated as transfer sensitivity analysis and, 369 payments because the loan tenns only Timing. With reference to PROJECTS, the divide the clains to goods and ser- choice of time to begin project imple- vices between borrowers and lenders mentation. When project BENEFITS and do not affect the total amount of will grow independently of project the RETURN TO CAPITAL. When a PRICE COSTS, it may be desirable to postpone differs from the MARGINAL VALUE a project. PRODUCT or VALUE IN USE, an in- mutually exclusive projects and, direct" transfer payment occurs equal 381-83 to the difference. Since transfer pay- Tradable. Capable of being TRADED ments represent shifts in claims to "Tradable but nontraded" goods and goods and services only and not use services are those which are not or new production, they do not in- traded because of government regula- crease or reduce NATIONAL INCOME; tion. In ECONOMIC ANALYSIS, the)y are hence, they are onutted when convert- treated as NONTRADED items if the reg- ig accounts used in FINANCIAL ulation is expected to persist during ANALYSIS 10 ECONOMIC VALUES used in the period under analysis. ECONOMIC ANALYSIS. Tradable but nontraded items (financial costs and benefits and direct, 50-52 price adjustment), 263-65. See also economic analysis and, 19, 317 TRADABLE. financial price adjustment and, 251 Traded. A project INPUT or OUTPUT is incremental net benefit and, 129 traded if its production or consunp- project costs and, 55 CLO',A R Y-INDEX 50.3 Transport, benefits and, 58, 59 aggregation and, 289 Transport projects, 255 agricultural projects and, 216 Treatment of uncertainty. See government cash flow and, 219 SENSITIVITY ANALYSIS Tree crop projects completion time and, 28 Valuation rate of return estimates and, 27-28 aggregation and, 293-94 Tunisia, forestry project in, 386-88, 389 incremental residual value and, Turvey, Ralph, 59, 300 117-19, 120, 121 intangible costs and benefits and, Uncertainty. See Risk; SENSITIVITY 61-62, 280 ANALYSIS price system based on, 11 Undiscounted measures of project projected farm production and, worth, 300-04. See also MEASURE OF 117, 120 PROJECT WORTH Value. See ECONOMIC VALUE UNDP. See United Nations Development Value added. The amount of ECONOMIC Programme (UNDP) VALUE generated by the activity car- Unemployment, seasonal employment ried on within each production unit and, 261, 262, 416-17 in the economy. Every farm, every Unit activity budget. In FARM factory, every hospital and school, ev- INVESTMENT ANALYSIS, a FARM BUDGET ery road and shop and cinema-each based on an easily segregated activity unit generates its own value added. such as planting a single hectare of a The sum of all the value added gener- crop or raising a particular group of ated by all production units equals animals. It is difficult to prepare a the total production of the country, unit activity budget on a WITH AND its NATIONAL INCOME measured as GDP WITHOUT basis; rather, it is generally (gross domestic product) or GNP (gross prepared on an incremental basis, national product). In any production with all cosTs and all BENEFITS in- unit, value added is measured by the cluded at the incremental value. For difference between the value of the both FINANCIAL ANALYSIS and OUTPUT of the firm and the value of ECONOMIC ANALYSIS, thts means that all INPUTS purchased from outside the for some elements the OPPORTUNITY firm. Thus, the value of output minus COST must be estimated directly, often the value of externally purchased in- especially difficult for land and for puts equals the value added. The FAMILY LABOR. As a result, unit activ- CAPITAL and labor attached to each ity budgets are most appropriate in firm are considered internal inputs, project analyses where the opportu- not externally purchased inputs. nity cost of land and family labor can "Gross value added" represents the be taken to be zero. Distinguished pool of INCOME, generated by produc- from WHOLE FARM BUDGET. See also tion, that is distributed to the FACTORS PARTIAL BUDGET OF PRODUCTION attached to the firm, cashew production example (India) of, including income TAXES and 142-46 DEPRECIATION. Deducting depreciation crops (aggregation methods) and, gives the net value added; the sum of 287-89, 291 all the net value added generated by defined, 141 production units in the economy is net financing and, 146-47 the net domestic product. "Domestic opportunity costs and, 142, 143, 146 value added" refers to the value added United Nations Development Pro- by local or domestic activities to com- gramme (UNDP), 438-39 ponents imported from abroad. United Nations Industrial Development Domestic value added in an INDI- Organization (UNIDo), 441 RECTLY TRADED item is the total value Upper, Jack L., 190, 203 of the product less the BORDER PRICE Upper Region Agricultural Development of the imported components. A "value Project (Ghana), 290, 291 added tax" 1s an INDIRECT TAX (also User fee. A charge levied upon users for known as an "ad valorem tax"-the the services rendered or goods sup- Latin phrase means "according to the plied by a PROJECT. See also COST value") levied at the time of each ex- RECOVERY INDEx and rent recovery change of goods and services from index. primary production to consumption, 504 GLOSSARY-INDEX Value added (continued) PARTIAL and UNIT ACTIVITY BUDGETS. generally stated as a proportion of the See also FARM BUDGET; PATTERN FARM value added at each stage of produc- PLAN tion. Willingness to pay, 60, 254. The amount aggregation methods and, 293, 294 consumers are prepared to pay for a indirectly taxed items calculation FINAL good or service. An estimate of and, 266 the VALUE IN USE. as indirect tax (income statement), economic values and, 245 197 foreign exchange premium and, 250 secondary costs and benefits and, 60 With and without. Refer to the situations Value of production forgone. The reduc- with and without a proposed project. tion in OUTPUT or reduction in NET In PROJECT ANALYSIS, the relevant BENEFIT that is a result of changing comparison is the NET BENEFIT with the use of an INPUT from one activity the project compared with the net to another. The value ofproduction benefit without the project. This is forgone is the OPPORTUNITY COST. distinguished from a "before and af- Value in use. A criterion of value in ter" comparison because even with- ECONOMIC ANALYSIS that takes as the out the project the net benefit in the ECONOMIC VALUE Of FINAL goods and project area may change. services the amount a purchaser is With and without comparisons, costs prepared to pay-that is, the pur- and benefits of proposed projects chaser's WILLINGNESS TO PAY Distin- and, 47-50 guished from the criterion for Without-project incremental net benefit, INTERMEDIATE goods and services, for 128 which the economic value is taken as Without-project nOt benefit after financ- the MARGINAL VALUE PRODUCT when ing, 212, 213 that good or service is used to pro- Without-project situations duce some other good or service. aggregation and, 291 Either the value in use or the mar- expansion and, 191 ginal value product of a good or ser- family labor and, 138 vice becomes the OPPORTUNITY COST land costs and, 139-40 when that good or service is shifted to valuing labor and, 260 another use. With-project farm budget, 127 van der Tak, Herman G., 20, 21, 60, 246, debt service and, 134 247, 248, 249, 254, 269 With-project situations aggregation and, 291 expansion and, 191 Wage rates, valuing labor and, 258-63 family labor and, 138 Wages land costs and, 139-40 development and rise in, 76 valuing labor and, 260 off-farm, 138 Work day The time devoted to an activitY Ward, William A., 247 by one person during one day. In Water charges, 216 agricultural PROJECTS in developing aggregation and, 289 countries, a work day is generally cost recovery example and, 223-24, taken to be eight hours in duration, 225-26 but in some agricultural situations a rent recovery and, 232 work da' of six hours is more realis- Water pollution, 16 tic A standard work day may some- Water resources planning publication times be established. It is usually the (1979), 345 work day of an adult male, with the Water resources, project preparation work of women and children assigned and, 415 some proportion of that standard. Weight The relative importance Working capital. The CAPITAL neCeSsarV to attached to some item. See purchase goods and services that are DISTRIBUTION WEIGHT; SAVINGS WEIGHT used for the production activities of West Africa. See also specific countries an enterprise and that are turned over price policy example and, 35 during the production cycle. For social environment example and, 32 farms, the capital necessary to pur- Whole farm budget. A budget for all ac- chase supplies (such as seed and ferti- tivities on a farm. Distinguished from lizer) and services (such as agricultu- CLOSSARY-INDEX 505 ral labor) needed during the produc- ally the work year of an adult male, tion of crops or livestock. The work- with the work of women and children ing capital is then recovered when the assigned some proportion of that crops or livestock are sold and so is standard. available for use in a subsequent pro- World Bank, 4, 76, 246, 359, 365, 438 duction cycle. From an accounting computer use and, 408 standpoint, literally all current ASSETS. consultant assistance and, 441, 442 'Net working capital" is the differ- cost recovery and, 226 ence between current assets and cur- government cash flow example and rent LIABILITIES. In practice, working loan from, 219 capital frequently also means net project analysis techniques and, 10 working capital. project audits (reviews) and, 26-27, farm investment analysis and, 98-99, 28, 29-30 126-27 projections of, 117 residual value and, 118-19 project preparation reports and, 411, sources-and-uses-of-funds statement 440-41 and, 202 sources-and-uses-of-funds example Work oxen and loan from, 198 computational conventions and, 165 culling rate and, 167 herd growth and, 180, 181 Yield, 365, 369. In agricultural use, the stable herd determination and, production of a crop or fodder per 177, 178 unit of area (for example, tons per Work year. The time devoted to an activ- hectare). In financial use, the RATE OF ity by one person during the course of RETURN on AN INVESTMENT. See also one year. A standard work year may High-yielding seed sometimes be established. It is usu- J. PRICE GITTINGER is coordinator of train- ing materials and publications and lectures on project analysis in the Economic Development Institute (EDI) of the World Bank. The full range of World Bank publications is described in the Catalog of World Bank Publica- tions; the continuing research program is outlined in World Bank Research Program: Abstracts of Current Studies. The most recent edition of each is available from the Publica- tions Unit, World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A. Training ma- terials and publications of EDI are described in the EDI Catalog of Training Materials; the most recent edition is available from the Training Materials and Publications Unit, EDI, World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A. All three booklets are available without charge and are updated annually. p,[(．꽈呵輸嶼『닉‘&-& ’써논， -:.,［」∥인4；큰 ：·，1,,&－」」＊&―■’&- & 크〃