REPORT ON PROJECT EVALUATION FOR KALAHI-CIDSS PROJECT, PHILIPPINES Introduction
This report considers the following project evaluation methodologies in the context of the KALAHI – Comprehensive and Integrated Delivery of Social Services (CIDSS) Project in the Philippines (“the Project”):
(a) financial analysis;
(b) economic analysis;
(c) social cost benefit analysis;
(d) other evaluation methods including willingness to pay, planning balance sheet and cost effectiveness analysis.
In order to analyse the relevance of the various evaluation methods to the Project, it is appropriate to have regard to the objectives of the Project. The overarching objectives of the Project as outlined in the logical framework for the Project were to: •
improve local governance;
reduce poverty; and
improve the quality of life of the poor.
By considering the various evaluation methodologies, it is possible to identify the evaluation methods that best apply to the Project, in light of its objectives. FINANCIAL ANALYSIS
Overview of financial analysis
Financial analysis is an essential part of project appraisal which is necessary to estimate the financial profit generated by a project. Financial analysis “…attempts to determine the net financial benefit (or loss) to an agency rather than the net benefit (or loss) to the economy or society. Financial evaluations are only concerned with cash flows in and out of the organisation.” (Commonwealth of Australia 2006, p. 28) Assessing the financial benefit of a project may be achieved through a consideration of the following: (a) net present value;
(b) financial internal rate of return.
Net present value
Net present value is calculated by “…discounting a project’s cash receipts using the minimum required rate of return on new investment (cost of capital), summing them over the lifetime of the proposal and deducting the initial investment outlay.” (Levy and Sarnat 1982, p.55) It is necessary to apply a discount rate, that is the minimum required rate of return on new investment, to future cash receipts to determine the present value of those profits.
The minimum required rate of return often reflects interest rates at which capital could otherwise earn interest in the market if it was not invested in a project. It is then necessary to sum the present value of cash receipts and deduct the initial cash investment for the project. Where the net present value is positive, the project may be accepted as financially viable. Financial internal rate of return
The financial internal rate of return is calculated by determining the rate at which the net present value of a project equals zero. (Brent 1990) In determining financial internal rate of return, future cash receipts must be time-discounted to present values to relate to the initial investment outlay for the project. Levy and Sarnat (1982, p.55) suggest that as a general principle, where financial internal rate of return exceeds the discount rate, that is the minimum rate of return on new investment, a project may be accepted. Application of financial analysis to the case study
Financial analysis is an essential valuation methodology to be applied to the
Project to determine its financial viability. One of the key objectives of the Project was to maximise the use of the World Bank funding in order to ensure that the Project was economically beneficial to the Philippines’ national economy. (Araral and Holmemo 2007, p. 8) The funding of the subprojects was to be provided in counterpart by provincial, municipal and barangay local governments, in addition to funding from communities and private sources. As Araral and Holmemo (2007, p. vii) indicate, such contributions were intended to reduce the fiscal impact of the project on the national government. Accordingly, it was necessary for the various investors to be confident of the profitability of the Project. Moreover, the World Bank (2001, p. 25-26) required a financial analysis of the Project in order to determine the cost effectiveness of the Project and ultimately, whether to provide a loan to the Philippines government.
However, it is noted that whilst carrying out a financial analysis is an essential aspect of project appraisal, there is a degree of uncertainty surrounding financial analysis at the outset of a project. This is particularly so in the context of developing countries where economic
uncertainty affects market prices. Moreover, a financial analysis does not take account of external costs or benefits. (Commonwealth of Australia Jan 2006) ECONOMIC ANALYSIS
Overview of economic analysis
Economic analysis has a broader focus than financial analysis, it considers “… the overall impact of a project on improving the economic welfare of the citizens of the country concerned. It assesses a project in the context of the national economy, rather than for the project participants or the project entity that implements the project. Economic analysis differs from the financial analysis in terms of both (i) the breadth of the identification and evaluation of inputs and outputs, and (ii) the measure of benefits and costs.” (Economics and Development Resource Centre Feb 1997, p.
The focus of economic analysis is the profitability of a project for society, rather than simply the project investor. Similar to financial analysis, through economic analysis, the net present value of a project may be calculated by summing the future flow of social benefits, less social costs (discounted to present values) and deducting the initial investment outlay. A project will be viable if the net present value of the project is greater than zero, that is, social benefits exceed social costs. Moreover, the economic internal rate of return may also be calculated for a project, by considering the net present value of a project taking into account social costs and benefits. The higher the economic internal rate of return, the more beneficial the project is to society.
Discounting must be factored into the calculation of these analyses, being the minimum required rate of return on new investment, as an expression of society’s preferences rather than on the basis of interest rate as is used in financial analysis. In order to measure the social costs and benefits of a project, it is necessary to determine the common unit of account or numeraire that benefits and costs should be expressed in. Thirwall (1983, p. 213) suggests that whilst the numeraire may be expressed in domestic prices or international prices, using world prices is justified as it “…avoids the use of the exchange rate in order to value in a single currency some goods measured at world prices (traded goods) and others measured at domestic prices (non-traded goods).”
It is also necessary, when carrying out economic analysis to adopt shadow prices. Shadow prices place a value on a factor for which there is inadequate market information, given that “…a project’s inputs and outputs should not necessarily be valued at current market prices because the market price may not reflect the social opportunity cost of the resource”. (Devarajan et al Feb 1997, p. 36) For example, in the context of labour, a project may
employ an individual at a certain wage, which represents a financial cost, however that financial cost does not represent the social cost of employment, being the supply price of labour. As such, a shadow price may be adopted to reflect the social opportunity cost of employment generated by the project.
Application of economic analysis to the case study
The Project sought to achieve several benefits beyond profitability, including improved infrastructure and services, increased community participation and improved quality of life. Accordingly, economic analysis is relevant in that it evaluates the Project’s benefits to all levels of government and to the community, rather than just the investors. An economic analysis can be carried out in respect of the infrastructure subprojects, as is evident in the analysis summarised by Aral and Holmemo (2007).
For example, it is possible to quantify the cost of construction and maintenance of roads against benefits such as number of households benefiting from a road and transport costs for paddy and fertilizer. (Aral and Holmemo 2007, p. 12) However, it should be noted that economic analysis is still confined to those benefits and costs that can be measured. Whilst economic analysis is clearly useful for assessing the economic benefits and costs of the infrastructure subprojects, other broader benefits, such as better access to social services and technology and possible benefits from improvements in barangay governance (Aral and Holmemo 2007, p. 21-22), are not captured through economic analysis.
SOCIAL COST-BENEFIT ANALYSIS
Overview of social cost-benefit analysis
Cost-benefit analysis involves the application of both financial analysis and economic analysis to a project to determine the strength of the project in being profitable and contributing to society. It “…attempts to measure the value of all costs and benefits that are expected to result from the activity. It includes estimating costs and benefits which are ‘unpriced’ and not the subject of normal market transactions but which nevertheless entail the use of real resources.” (Commonwealth of Australia Jan 2006, p. 5) Moreover, this analysis involves a consideration of distributional issues, that is, how benefits and costs from a project are distributed amongst private and public sectors. (Little and Mirrlees 1990, p. 352)
Application of social cost-benefit analysis to the case study The use of social cost-benefit analysis as a method of evaluation for the Project is beneficial in combining a consideration of the financial viability of the project and the costs and benefits of the Project for society as a whole.
It is relevant to turn to the scenarios for cost-benefit analysis for the case study. For roads, the best scenario for both road construction and road improvement is scenario 3. This is because whilst the net present value and economic internal rate of return for both scenario 1 and scenario 3 is the same for both road construction and road improvement, the discount rate for scenario 3 in both instances is less than that for scenario 1. That means that the economic internal rate of return is proportionally greater than the discount rate in scenario 3 and as such the return on those projects is greater than it would be for the scenario 1 projects. Furthermore, in the case of both road construction and road improvement, scenario 2 is the worst scenario, as the net present value is significantly less than the other scenarios and also the economic internal rate of return is lower.
The higher the internal rate of return, the more beneficial the project. Overall, road construction under scenario 3 is a better option than road improvement as both the net present value and economic internal rate of return is greater for road construction than road improvement. For school building, whilst scenario 1 and scenario 3 have the same economic internal rate of return (15.91%) and the net present value for scenario 1 (at 42,729 USD) is slightly higher than that of scenario 3 (at 42,000 USD), scenario 3 is the best option as the economic internal rate of return is proportionally greater than the discount rate at 10%, rather than under scenario 1 where the discount rate is 15%. Accordingly, scenario 2 is the worst option with the lowest net present value and an economic internal rate of return which is less than the discount rate. Where economic internal rate of return is less than the discount rate the project should not be considered.
As such, scenario 2 should not be considered. For school improvement, scenario 1 and scenario 3 have the same net present value (22,930 USD) and economic internal rate of return (15.10%), however scenario 3 is more favourable given that its economic internal rate of return is proportionally greater than its discount rate (10%) than scenario 1’s discount rate (15%). Scenario 2 is the worst option given that it has a lower net present value than the other scenarios and its economic internal rate of return is less than its discount rate and as such it should not be considered. Overall, school building under scenario 3 is a better option than road improvement as the net present value of the project is greater and the proportional relationship between economic
internal rate of return and discount rate is higher for school building than for school improvement.
OTHER EVALUATION METHODS
Overview of other evaluation methods
Willingness to pay
Willingness to pay examines how much a person is willing to pay for a good or service. The value that a person is willing to pay is then compared to the actual cost of the good or service. This technique relies on data collection through surveying people in a community in which a project is proposed. For example, Whittington et al (1990) surveyed a village in southern Haiti regarding willingness to pay for water services. Whilst it is suggested that the viability of willingness to pay surveys is limited given the scope for bias in individuals’ responses, Whittington et al concluded that such surveys were a feasible method of estimating willingness to pay for improved water services (1990, p. 308). Planning balance sheet
This evaluation methodology attempts to list ‘intangible’ benefits of a project and also involves an analysis of the distribution of project benefits amongst society. Cost-benefit analysis only considers those benefits that can be easily measured. As Materu (1985, p. 4) suggests, “…the tendency to select projects on the basis of their expected quantified monetary benefits, with intangibles treated as a minor balancing factor – which is inherent in traditional forms of cost-benefit analysis, can be misleading because it may not reflect the true social value of an investment.” The planning balance sheet approach attempts to focus on all costs and benefits of a project to the community rather than simply quantifiable economic costs and benefits.
Cost effectiveness analysis
Cost effectiveness analysis involves an assessment of the cost of investment in a project against the benefits measured on the basis of physical units rather than monetary value, for example, number of lives saved or children provided with an education. This enables an evaluation of the effectiveness of money spent to achieve program objectives. Cost effectiveness analysis is valuable for assessing the cost-effectiveness of alternatives programmes with similar objectives, where the project objectives are clearly defined.
Application of other evaluation methods to the case study
Whilst the willingness to pay approach might be suitable in respect of the infrastructure subprojects that are part of the case study, this evaluation method is not suitable for taking account of the broader aspects of the Project, such as improved community participation and quality of life. However, the planning balance sheet approach is likely to be useful in analysing the benefits of those aspects of the Project, given that they are difficult to quantify in a monetary sense.
In considering cost effectiveness analysis, whilst there may be some value in measuring the benefits of the Project on the basis of units such as number of people engaged in community decision-making, however this would be difficult to measure given the broad scope of the Project wherein programmes for improved governance and participation are to be tailored to local barangay communities. As such, this method of evaluation would not produce consistent results for carrying out preliminary appraisal of the Project. Conclusions
Conducting a financial analysis is an essential part of appraisal for the Project in order to determine the financial profitability of the project for the investors. However, it is relevant to examine other aspects of the project to determine its viability given the objectives were broader than merely financial objectives. Economic analysis is relevant to apply market prices to the costs and benefits of the Project to society, rather than just the investors in the project. This enables a consideration of the net benefits of the Project as against the cost of capital expenditure required to implement the Project.
Financial analysis and economic analysis are both relevant to conducting a meaningful evaluation of the Project, however, they are of limited use if applied independently. As such, social cost-benefit analysis offers an effective methodology for assessing both the financial and economic costs and benefits of the Project, and enables a consideration of how those costs and benefits would be distributed amongst various sectors within society. By applying social cost-benefit analysis, it is possible to determine whether the benefits outweigh the costs of the project to the extent that the capital should not be invested elsewhere.
However, whilst social cost-benefit analysis can be used to assess benefits and costs of those aspects of the Project that are easily quantifiable, such as the infrastructure subprojects, this method does not give weight to the benefits and costs associated with the intangible objectives of the Project such as increased community participation, improved local governance and quality of life. Here, the planning balance sheet approach is useful as a means to give weight to the intangible benefits of the Project to society.
Aral, E. and Holmemo, C. 2007, ‘Measuring the Costs and Benefits of Community
Driven Development: The KALAHI-CIDSS Project, Philippines’, Social Development Papers – Paper No. 102.
Brent, R. 1990, “Investment Criteria”, Chapter 2 in Project Appraisal for Developing Countries, New York: Harvester Wheatsheaf, pp. 24-39.
Commonwealth of Australia. January 2006, Introduction to Cost-Benefit Analysis and Alternative Evaluation Methodologies, Department of Finance and Administration. [online] http://www.finance.gov.au/publications/finance-circulars/2006/01.html [Accessed 9 October 2011]
Devarajan, S., Squire, L. and Suthiwart-Narueput, S. February 1997, “Beyond Rate of Return: Reorienting Project Appraisal”, The World Bank Research Observer, 12(1), pp. 3546. Economics and Development Resource Centre. February 1997, Guidelines for the Economic Analysis of Projects, Asian Development Bank. [online]
http://www.adb.org/Documents/Guidelines/Eco_Analysis/eco-analysis-projects.pdf [Accessed 3 October 2011]
Levy, H. and Sarnat, M. 1982, “The Economic Evaluation of Investment Proposals”, Chapter 3, in Capital Investment and Financial Decisions, 2nd ed., Englewood Cliffs, NJ: Prentice Hall International, pp. 39-64.
Materu, J. 1985, “A Planning Balance Sheet of a Sites and Services Project in Tanzania”, University of Sheffield Department of Town and Regional Planning Occasional Paper Number 57.
Thirwall, A. 1983, “Social Cost-Benefit Analysis and the Shadow Wage”, Growth and Development with Special Reference to Developing Economies, London: Macmillan, pp. 202-216.
Whittington, D., Briscoe, J., Mu, X. and Barron, W. 1990, “Estimating the Willingness to Pay for Water Services in Developing Countries: A Case Study of the Use of Contingent Valuation Surveys in Southern Haiti”, Economic Development and Cultural Change, pp. 293311. World Bank. 2010, The World Bank Annual Report 2010, The International Bank for Reconstruction and Development, The World Bank, Washington DC. [online]
http://siteresources.worldbank.org/EXTANNREP2010/Resources/WorldBankAnnualReport2010.pdf [Accessed 10 August 2011]