’Financial and Economic analysis for Investment Projects:
Core issues & Key tasks for Design & Review’

Core
issues:

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

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

Accurate
estimation of financial benefits. A critical variable for the
estimation of incremental benefits is the adoption/adaptation rates of new
technologies and enterprises. The case for change is usually made on the
basis of technical and financial viability, but adoption rates also depend
on: the risk perceptions and risk mitigation strategies of the target
group, the labour and cash flow constraints of households, reliability and
complexity of technology, and other social factors that can determine
individual preferences and motives. Moreover, the commercialisation of
outputs hinges on the assumption of existing demand and of a functioning
market. These assumptions should be appropriately examined in order to
arrive at realistic estimates of producer prices and sales volumes. Demonstration
of financial viability and sustainability.
The routine test of financial viability for general or special projects is
the financial analysis for the indicative private enterprises. The
analysis should also encompass the viability of the institutions that is
either participating or being formed under the project, in order to ensure
that service provision can be sustained past the financing period. Cost
recovery is key to financial sustainability and when services are provided
on that basis the formulation should include an analysis of demand for
them. However, the willingness and ability of the rural poor to pay for
project supported services and outputs, and the capacity of institutions
and service providers to charge for them, remains an issue that should be
critically examined. Assessment
of social costs and benefits. Economic analysis is
traditionally used to correct financial prices for distortions and
transfer payments. Extended CBA can also account for externalities and
other social costs and benefits. This may require complex shadow pricing
methods and value judgments?, but key pecuniary externalities common to
agricultural development (e.g. upstream/downstream links in watersheds)
should be accounted for in the analysis, when they are linked to a
significant portion of the project?s costs and benefits. (5) Uncertainties
in attribution of costs and benefits: Flexible
financing instruments such as Community Development Funds will generate
unpredictable cost and benefit streams. An analysis that is based on some
indicative activities to be undertaken is feasible in some cases by
assuming a menu of options for the target group. Uncertainty can weigh on
more structured project designs as well, especially for research and
extension activities. This is due to the large time lags for the accrual
of benefits from research and extension services and the inherent
serendipity of research outcomes.

Key
tasks for design and review:

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

Conclusion:
Financial and
Economic analysis for Investment Projects is very much relevant and essential,
especially to find out Core
issues, Key tasks for design and review and judge its commercial prospects.

?

Adri MitraAsst. ProfessorMIT.