8/12/2019 New MicrosFinancial and economic analysis for investment projectsoft Word Document

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Financial and economic analysis for investmentprojects

Learning notePrint this page

This Note relates to KSF3: Alignment of design features with IFAD Strategic Objectives and lessons learnt; analysis andresults framework Version: January 2008

Core issues

The design of rural development investments should include tests of financial viability and sustainability, as well as ademonstration of the value of the project to the economy in general. Financial and Economic Analyses provide therelevant ex-ante evidence within the frameworks of Discounted Cash Flows and Cost Benefit Analysis (CBA). Theprinciples that guide these frameworks are long established and well documented. However, the value of the analysisas a decision tool hinges on the quality of the assumptions that underpin it, as well as its ability to capture a variety ofcosts and benefits and accurately predict the project outcomes. Related to the above, some core issues to co nsider inthe context of Quality Enhancement are:

Accurate estimation of financial costs . Inaccuracy of early cost estimates can be partly attributed to incompleteinformation and inherent difficulties in predicting a distant future. However, there is a marked bias towardsunderestimation, which frequently results from inadequate assessments of: local capacity for diligent andexpedient implementation; availability of inputs locally/internationally; efficiency of procurement; and timelyavailability of counterpart funds.

Accurate estimation of financial benefits . A critical variable for the estimation of incremental benefits is theadoption/adaptation rates of new technologies and enterprises. The case for change is usually made on thebasis of technical and financial viability, but adoption rates also depend on: the risk perceptions and riskmitigation strategies of the target group, the labour and cash flow constraints of households, reliability andcomplexity of technology, and other social factors that can determine individual preferences and motives.Moreover, the commercialisation of outputs hinges on the assumption of existing demand and of a functioningmarket. These assumptions should be appropriately examined in order to arrive at realistic estimates ofproducer prices and sales volumes.

Demonstration of financial viability and sustainability. The routine test of financial viability for IFADs projects isthe financial analysis for the indicative private enterprises. The analysis should also encompass the viability ofthe institutions that are either participating or being formed under the project, in order to ensure that serviceprovision can be sustained past the financing period. Cost recovery is key to financial sustainability and whenservices are provided on that basis the formulation should include an analysis of demand for them. However,

the willingness and ability of the rural poor to pay for project supported services and outputs, and the capacityof institutions and service providers to charge for them, remains an issue that should be critically examined.

Assessment of social costs and benefits. Economic analysis is traditionally used to correct financial prices fordistortions and transfer payments. Extended CBA can also account for externalities and other social costs andbenefits. This may require complex shadow pricing methods and value judgements, but key pecuniaryexternalities common to agricultural development (e.g. upstream/downstream links in watersheds) should beaccounted for in th e analysis, when they are linked to a significant portion of the projects costs and benefits.

Uncertainties in attribution of costs and benefits : Flexible financing instruments such as CommunityDevelopment Funds will generate unpredictable cost and benefit streams. An analysis that is based on someindicative activities to be undertaken is feasible in some cases by assuming a menu of options for the targetgroup. Uncertainty can weigh on more structured project designs as well, especially for research andextension activities. This is due to the large time lags for the accrual of benefits from research and extension

services and the inherent serendipity of research outcomes. Lastly, the problem of attribution of costs andbenefits applies especially to IFAD projects that engage in wider donor programme initiatives, such as aSWAp, in which case an ex- ante CBA on IFADs contribution may not be the appropriate decision tool.

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Key tasks for design and review

Describe the project costs clearly and succinctly in the project document and the cost tables, in appropriatedepth. Above all, keep the project expenditure accounts transparent and unambiguous in all cases, andinclude estimates of fees and per diems for services paid by the project in distinct accounts. Use standardsoftware (COSTAB) to enable: the aggregation and display of investment and recurrent costs at differentlevels and forms; the presentation of unit costs and quantities; the links to disbursement and procurementaccounts; and the estimation of physical and price contingencies. Present clearly the assumptions and thesources of data.

Formulate the without-project scenario in the financial and economic analysis, taking into account underlyingtrends in technology, policy, local economy and physical environment in the project and wider system area, inorder to reflect changes in productivity (positive or negative) that would have occurred without the intervention.For the with-project scenario in economic analysis, check for possible substitution effects to determine netincremental output and impact.

For the financial analysis, present appropriate measures of the attractiveness of the investment to the targetgroup. Return to capital calculations can be supplemented with returns to labour and land. Check theassumptions underpinning the enterprise models with regard to availability of inputs, labour, and whenrelevant- access to credit. Estimate uptake rates for the proposed project activities based when possible on

past project experiences, and preferably with references to M&E and supervision reports. Examine thedistribution of incremental benefits and incremental private costs along the value chain in order to arrive atrealistic producer prices.

Include an analysis of demand (with due consideration to willingness to pay and affordability for IFAD targetgroups) for project supported services that are provided on a partial or full cost recovery basis.

Undertake economic analysis using standard shadow pricing methods for the adjustment of financial pricesand the elimination of transfer payments to reflect the economic prices of resources. Extend shadow pricing toestimate significant non-marketed project outputs and impacts.

Calculate rates of return at the level of the whole project where the total cost of infrastructure, agriculturaldevelopment, irrigation, and other hard investments, is dominant in the cost tables. The analysis will be moreinformative if rates of return are also calculated separately per component and/or a combination of them.

Test key project assumptions and risks using sensitivity and risk analysis . At the enterprise level, importantparameters for testing are variability of yields and seasonal price volatility; and at the project levelimplementation delays and availability of counterpart financing (especially the projected contributions fromtargeted communities and government institutions to meet O&M and other recurrent costs; and donor co-financing for critical investment components). Use switching values for sensitivity analysis, and justify thechoice of scenarios examined.