V INTRODUCTION This manual is the outcome of a process of reflection by the Commission of the European Communities. It responds to the Commission's concern to analyse the results and the viability of development projects. The methodology adopted aims to highlight the financial and eco- nomic data most useful in analysing development projects and in assessing their impacts on the economy. Projects financed by the Commission are of different kinds: e.g., educational projects, agricul- tural projects, urban projects, projects supporting small enterprises, health projects. The manual looks at all of these from an economist's perspective. Financial and economic analysis pro- vides a partial view of projects which complements analyses by technical, social and environ- mental specialists and analyses on consistency with the sectoral policies. The basic idea of the proposed methodology is that projects can be analysed from different points of view, each providing useful information: its budget, financial viability, impact on economic policy objectives, etc. These different points of view highlight the variety of incen- tives and constraints facing project participants and the stakes and risks for the national economy of undertaking the project. The ultimate purpose of financial and economic analysis is to determine, as accurately as possible, the costs, efficiency of resource use (especially the financial and economic return on investments), and the relevance of projects to current economic policies and structural re- forms. This manual provides a comprehensive methodology. Should one systematically apply all the stages of analysis proposed in this manual for all projects? Ideally, the answer is yes. One could then judge the project in a number of different and complimentary ways. But in practice, the answer must be no. Analysts generally have insufficient time and re- sources. Choices must thus be made depending on the specific questions raised by the project and the resources available. Generally speaking: (cid:1) A DETAILED FINANCIAL ANALYSIS of the all participants involved (e.g., enterprises, artisans, public institutions, farmers... – Chapter 3) is essential when: (cid:127) doubts exist as to the implications for key actors/entities of the project; (cid:127) it is important to know the precise impact of the project on certain actors or entities; and (but in less detail) to prepare the data necessary for economic analysis. (cid:1) A CONSOLIDATED ACCOUNT ANALYSIS (Chapter 4) is needed only if the project in- volves a number of entities whose activities form an inseparable whole. VI (cid:1) ANALYSIS OF THE PROJECTS'S EFFECT ON ECONOMIC OBJECTIVES (Chapters 5 and 7) is necessary when: (cid:127) project size is large relative to the national economy; (cid:127) the project's foreign currency balance needs to be known (e.g., import substitu- tion or export projects); (cid:127) the project's impact on public finances needs to be known; (cid:127) the distribution of income is an important part of the intended effects (e.g., in the case of projects in areas with a high level of unemployment, projects aimed at alleviating poverty, projects leading to changes in the consumer price of goods and services); (cid:127) the project aims to support enterprises (e.g., credit-line projects or leading to changes in the prices of intermediary goods and services). (cid:1) AN ANALYSIS OF THE PROJECTS'S VIABILITY WITHIN THE INTERNATIONAL ECONOMY (Chapters 6 and 7) is necessary: (cid:127) when project size is large relative to the national economy; (cid:127) for projects directly linked to international markets and which need to be com- petitive (e.g., import substitution or export projects); (cid:127) when the sector or subsector involved is subject to strong government interven- tion or non competitive practices (e.g., monopoly); (cid:127) in economies where the exchange rate is maintained at "artificial levels"; (cid:127) in economies requiring major structural adjustment. (cid:1) AN ANALYSIS OF PROJECTS WITH NON-TANGIBLE PRODUCTS (Chapter 8) should be systematically undertaken and be as thorough as possible in respect of budgets and the efficiency with which material and human resources are used. On the other hand, the economic effect of the expenses incurred should only be analysed when: (cid:127) the size of the project is very large; (cid:127) one of the objectives is the distribution of incomes; (cid:127) inputs have to be imported while foreign currency availability is a major con- straint; (cid:127) selection among alternatives with comparable costs must be made. These are just examples. Policy makers and planners need to define what is expected in each case. Project analysts should then use their judgement on the specific types of analysis which they undertake, based on their own experience. VII To the well informed reader: The financial and economic analysis of development projects has, in the past, resulted in a wealth of publications and, sometimes, in controversies among specialists. In the method proposed here, project analysis techniques are presented in a pragmatic way showing what information they can provide to decision makers. The desire to be practical has led to a simplified application of the following techniques: (cid:1) budgeting and the financial analysis of projects – i.e. simplified adaptations of tradi- tional accounting methods; (cid:1) the ways of estimating the effects on growth, incomes and the main macro-economic balances (foreign exchange, public finances), known as the Effects Method; (cid:1) the widely applied calculations of the economic contribution of projects, based on the estimation of 'opportunity costs', from Shadow Pricing Evaluation Methods. Several of the concepts used in this manual have had more than one definition or interpreta- tion, depending on who is writing about them. The ways in which they are presented here correspond to decision makers' concerns, especially regarding operationality and homogeneity of studies. The more informed readers (including specialists) are thus encouraged to refer to the definitions and methodological presentations in Chapter 1 and Annexes B & C. This manual describes the general approach of financial and economic analysis, applied to all types of development projects. To complement this manual, various sectoral applications will be produced, later, as case studies. Internal instructions relative to the main kinds of programmes and projects funded by the Directorate-General for Development (DG VIII) will also be produced. IX TABLE OF CONTENTS PREFACE...................................................................................................III INTRODUCTION......................................................................................... V ABBREVIATIONS.....................................................................................XIX USER'S GUIDE......................................................................................XXI Outline of the manual.......................................................................... XXIII Suggestion for a first reading .............................................................. XXV Types of project................................................................................... XXVI Chart of the main stages of analysis................................................. XXVII 1. FINANCIAL AND ECONOMIC PROJECT ANALYSIS: AAAAA DDDDDEEEEECCCCCIIIIISSSSSIIIIIOOOOONNNNN MMMMMAAAAAKKKKKIIIIINNNNNGGGGG TTTTTOOOOOOOOOOLLLLL............................................................................................................................................................................................................................................................................................................ 11111 1.1. What are financial and economic project analyses used for?.........4 1.1.1. What is a development project? .................................................. 4 1.1.2. An aid to decision making ......................................................... 6 1.1.3. Different areas of analysis.......................................................... 7 1.2. The analytic approach ......................................................................8 1.2.1. Different types of development project .......................................... 9 1.2.2. Analysis of projects with tangible products....................................11 (a) Financial analysis..............................................................11 (b) Economic analysis ............................................................12 1.2.3. Analysis of projects with non-tangible products...............................14 1.2.4. Use in the project cycle ...........................................................16 1.3. Some key concepts.........................................................................17 1.3.1. Entities and flows...................................................................18 1.3.2. The project's incremental contribution ..........................................19 X 1.3.3. Taking time into account ..........................................................19 1.3.4. Risk and uncertainty ...............................................................21 (a) Contingencies .................................................................22 (b) Sensitivity analysis ............................................................22 1.4. Summary of financial and economic project analysis...................24 2. INTEGRATION OF THE PROJECT WITHIN THE DOMESTIC ECONOMY .............................................................27 2.1. Definition of the "with" and "without" project situations..............30 2.1.1. The direct impact on production.................................................30 2.1.2. The use of scarce means of production ........................................32 2.1.3. Determination of the alternative..................................................34 2.2. Identification of the entities involved in the project.....................37 2.2.1. Problem positioning................................................................37 2.2.2. Identification of the entities to be studied ......................................38 2.3. Summary of procedure of the analysis of integration of the project within the domestic economy.................................41 Case study................................................................................................43 3. BASIC TECHNIQUES FOR THE FINANCIAL ANALYSIS OF ENTITIES....................................................................................49 3.1. With-project situation .....................................................................52 3.1.1. Investment costs ...................................................................52 (a) Investments ....................................................................53 (b) Provisions for contingencies.................................................55 3.1.2. Operating costs and benefits ....................................................56 3.1.3. Financing plan ......................................................................56 (a) Working capital ................................................................58 (b) Financing scheme.............................................................59 3.1.4. Financial statements and indicators.............................................65 (a) The accounts...................................................................65 (b) Indicators of financial efficiency ............................................65 XI (c) The break-even point .........................................................66 3.1.5. Solvency and viability..............................................................67 3.2. Without-project situation ..................................................................68 3.2.1. Flow forecasts.......................................................................68 3.2.2. Financial statements ...............................................................69 3.3. Investment returns on incremental flows......................................69 3.3.1. Investment returns before financing.............................................69 (a) Purpose.........................................................................69 (b) Criteria used ...................................................................70 (c) Sensitivity analysis ............................................................71 3.3.2. Investment returns after financing...............................................71 (a) Purpose.........................................................................71 (b) Criteria used ...................................................................72 (c) Sensitivity analysis ............................................................72 3.4. Disbursement schedule ..................................................................73 3.5. Summary of financial analysis procedure .......................................75 Case study................................................................................................77 4. CONSOLIDATED ACCOUNT ANALYSIS...........................................85 4.1. Basic technique ..............................................................................88 4.1.1. Method...............................................................................88 4.1.2. Problems and precautions........................................................91 4.2. Overall evaluation of the activities induced by the project ..........92 4.2.1. Viability...............................................................................92 4.2.2. Overall efficiency ...................................................................93 (a) General features...............................................................93 (b) Productivity and unit costs...................................................93 (c) Overall return on investment.................................................94 4.2.3. Sensitivity analysis .................................................................96 4.3. Recurrent costs and disbursement schedule ................................96 4.3.1. Financing of recurrent costs......................................................96 4.3.2. Consolidated disbursement schedule ..........................................98 XII 4.3.3. Sensitivity analysis .................................................................99 4.4. Summary of procedure for consolidated account analysis.........100 Case study..............................................................................................101 5. THE ANALYSIS OF EFFECTS ON MAJOR ECONOMIC POLICY OBJECTIVES..............................107 5.1. Total effects calculation...............................................................111 5.1.1. Direct effects...................................................................... 111 5.1.2. Indirect effects.................................................................... 114 (a) Manual calculation of backward linkages ............................... 115 (b) The statistical calculation .................................................. 116 (c) The calculation of indirect effects in practice........................... 118 5.1.3. Total effects........................................................................ 119 5.2. Incremental effects calculation ...................................................121 5.2.1. Incremental effects linked to production...................................... 121 (a) Projects satisfying the same domestic demand........................ 121 (b) Export projects .............................................................. 123 5.2.2. Incremental effects linked to consumption................................... 124 (a) Consumer benefit ........................................................... 125 (b) Quantitative changes in meeting domestic demand .................. 126 5.2.3. Overall incremental effects ..................................................... 127 5.2.4. Underlying assumptions ........................................................ 129 5.3. Effects analysis.............................................................................130 5.3.1. Contribution to growth........................................................... 131 5.3.2. Contribution to the foreign exchange balance............................... 134 5.3.3. Contribution to the public funds balance..................................... 137 5.3.4. Balance of income distribution................................................. 142 5.4. Summary of procedure of the analysis of effects on the major economic policy objectives ....................................143 Case study..............................................................................................145 XIII 6. ANALYSIS OF THE VIABILITY OF THE PROJECT WITHIN THE INTERNATIONAL ECONOMY .................................................155 6.1. Presentation of the approach.......................................................159 6.1.1. Theoretical foundation of analysis by prices................................. 160 6.1.2. The applied method: international parity prices............................. 164 6.2. Method of calculation ...................................................................166 6.2.1. Elimination of transfers .......................................................... 167 6.2.2. Breakdown of goods and services into "tradeables" and "non-tradeables" ............................................................ 168 6.2.3. Valuation of tradeable goods and services .................................. 168 (a) Import/export parity prices ................................................ 168 (b) Projection of international prices.......................................... 172 (c) Shadow exchange rate..................................................... 172 6.2.4. Valuation of non-tradeable goods and services............................. 174 (a) The types of non-tradeable goods and services....................... 174 (b) Local value ................................................................... 175 (c) Breakdown into tradeable goods and services ........................ 177 6.2.5. Drawing up the accounts ....................................................... 179 (a) Transforming of the consolidated account .............................. 179 (b) The policy analysis matrix.................................................. 180 6.2.6. Underlying assumptions ........................................................ 182 6.3. Analysis of the project's viability in the international economy........................................................................................183 6.3.1. Income generation ............................................................... 184 (a) The balances................................................................. 184 (b) The transfers ................................................................. 184 6.3.2. Integration in the international market......................................... 186 (a) Protection..................................................................... 186 (b) Competitiveness............................................................. 188 6.4. Summary of procedure for the analysis of viability within the international economy..............................189 Case study..............................................................................................193 XIV 7. ANALYSIS OF THE ECONOMIC EFFICIENCY AND RELEVANCE OF THE PROJECT.............................................199 7.1. Economic profitability...................................................................202 7.1.1. From the perspective of domestic income ................................... 205 7.1.2. Under foreign currency constraints............................................ 208 7.1.3. From the standpoint of the international economy .......................... 210 7.2. Economic relevance......................................................................212 7.3. Summary of procedure for the analysis of a project's efficiency and economic relevance..............................................216 Case study..............................................................................................217 8. ANALYSIS OF PROJECTS WITH NON-TANGIBLE PRODUCTS......219 8.1. Defining the results.......................................................................222 8.1.1. Selection of indicators........................................................... 223 8.1.2. The project's real contribution.................................................. 226 8.2. Sustainability study ......................................................................226 8.2.1. Budget plan....................................................................... 227 (a) General approach........................................................... 227 (b) Estimation of the project cost ............................................. 229 (c) Fees and cost recovery .................................................... 229 8.2.2. Financing of recurrent costs.................................................... 230 8.2.3. Sustainability of the activities generated by the project.................... 232 8.3. Efficiency analysis........................................................................232 8.3.1. Examination of unit costs........................................................ 233 8.3.2. Use of necessary and sufficient resources................................... 235 8.4. Analysis of economic effects .......................................................236 8.4.1. Public funds....................................................................... 237 8.4.2. Foreign exchange................................................................ 239 8.4.3. Income distribution............................................................... 241 8.5. Analysis of relevance....................................................................241 XV 8.6. Summary of procedure for analysis of projects with non-tangible products...........................................................242 ANNEX A – TAKING TIME INTO ACCOUNT.......................................245 A.1. Current prices and constant prices .............................................247 A.2. Discounting ...................................................................................251 A.3. Opportunity cost of capital...........................................................253 ANNEX B – FINANCIAL COST-BENEFIT ANALYSES: AN OVERVIEW ................................................................255 B.1. General simplified procedure .......................................................258 B.2. Cash flow analysis........................................................................258 B.3. Flow balance analysis ..................................................................260 B.4. Operations analysis ......................................................................262 ANNEX C – ECONOMIC COST-BENEFIT ANALYSES: AN OVERVIEW ................................................................271 C.1. Simplified general procedure........................................................274 C.2. Consolidated account analysis ....................................................275 C.3. Analysis of the effects on the economic objectives ...................277 C.4. Analysis of viability within the international economy ...............281 C.5. Analysis of economic efficiency and relevance ..........................284 ANNEX D – PRINCIPAL TABLES OF FINANCIAL ANALYSIS..............287 D.1. The cash flow statement..............................................................289