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Project Appraisal

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Project Appraisal © Centre for Financial and Management Studies SOAS, University of London First published 2013, revised 2014, 2015

All rights reserved. No part of this course material may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, including photocopying and recording, or in information storage or retrieval systems, without written permission from the Centre for Financial & Management Studies, SOAS, University of London.

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Course Introduction and Overview

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1 Introduction

This is a course about financial and economic appraisal of projects. The project is a very specific element of the public policy and management mix. It normally consists of an investment – that is, the creation of an asset which will generate benefits, financial and non-financial over a period of more than one year. This is not universally applicable as a working definition, as ‘project’ is often used to describe a set of discrete activities that do not always involve a capital investment, to achieve some specific goals. In this course, however, we will be dealing with capital investments. Financial appraisal involves predicting the financial flows, both expendi- tures and revenues, associated with the investment. Companies make such appraisals when choosing where and how to invest, and such financial appraisal is at the heart of the appraisal process. Economic appraisal is often used for public project appraisal because some of the relevant flows in- volved are not financial. The benefits of a public investment may consist, in part, of social benefits that do not have a monetary value. Some of the costs incurred, such as environmental impact of an infrastructure investment, may also have no market value. The normal approach with such non- financial flows is to find ways of measuring the costs and benefits and attributing a monetary value to them. How do these two sorts of appraisal fit into the public policy-making pro- cess? Often, an appraisal is a formal requirement^1 for any investment above a set financial limit, and a specified projected rate of return is a requirement for approval. This applies at all levels of government and is often imposed as a decision rule by the Ministry of Finance. Such a requirement does not necessarily imply that all available options have been considered. This is one of the limitations of project appraisal that you will see as you go through the course: a project may have political backing for various reasons and the appraisal process is designed to support a decision that has already been made. A more productive use of appraisal is to inform the decision-making process. There may be a variety of ways of solving a policy problem^2 , with different rates of return, or different costs for the same results. The comparison of projects to find the best return on a public investment can be an important part of the policy decision process, if it is done in a timely manner. Some decisions, of course, are made for reasons other than the projected economic, financial or social returns. Some of the very big investment projects in history, such as the construction of the Panama Canal, the Suez Canal, the tunnel between Britain and France, the Hoover Dam in the USA or more recent projects such as the Three Gorges Project or the construction of the high speed train network in China were made without the benefit of

(^1) In the USA, a cost-benefit analysis and consideration of alternatives has been a legal requirement since the River and Harbors Act 1902, and various laws since that time. (^2) If you have studied Public Policy and Strategy you will be familiar with the wide variety of policy instruments available to policy makers.

Course Introduction and Overview

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Unit 5 Sector Analysis and Case Studies in SCBA

5.1
Introduction

5.2
Transport Projects

5.3
Water

5.4
Education

5.5
Environment

5.6
Health Care

5.7 Cost-Effectiveness Analysis (CEA)

5.8
Summary and Review

Unit 6 Risk and Uncertainty Analysis

6.1 Introduction 6.2 Risk and Uncertainty 6.3 Techniques for Risk Analysis 6.4 Uncertainty 6.5 Risk and Large Projects 6.6 Spreadsheet Modelling and Risk Analysis 6.7 Summary and Conclusions

Unit 7 Distributional Issues and Social Cost-Benefit Analysis

7.1 Introduction 7.2 Analysing the Distribution of Costs and Benefits 7.3 Displaying Distributional Impacts 7.4 Distributional Weighting 7.5 Multi-Criteria Analysis (MCA) 7.7 Summary and Conclusions

Unit 8 Critique and Reflection

8.1
Introduction

8.2
Standings, Value Assumptions, and Legitimacy of Cost-Benefit Analysis

8.3
The Strengths and Limitations of Social Cost-Benefit Analysis

8.4
SCBA in Developing Countries

Preparation for the Examination

Unit Content

Units 1 and 2

Units 1 and 2 consider the investment appraisal techniques that are used in the private sector. Investment is defined as real capital formation such as the production or maintenance of machinery or housing construction; these types of investment will produce a stream of goods and services for future consumption. Investment involves the sacrifice of current consumption and the production of investment goods, which are used to produce goods or services, and it includes the accumulation of inventories. Investment ap-

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praisal is the evaluation of prospective costs and revenues generated by an investment in a capital project over its expected life. Such appraisal includes the assessment of risks (although this is covered separately in Unit 6) and uses a number of different techniques for deciding whether to commit resources to the project. These techniques include discounted cash flow (DCF) and the calculation of net present value (NPV) internal rate of return (IRR).

Unit 3

Unit 3 develops the theoretical and applied aspects of Social Cost-Benefit Analysis. The basic tools of SCBA consider the direct costs and benefits of a project but also the wider costs and benefits at the level of the national or regional economy of a country. Social cost-benefit analysis is used mainly for projects where there is public sector investment and where there are wider development aims over and above those of generating revenues and profits, which are the main concern of the private sector.

Unit 4

Unit 4 is about the main valuation techniques of Revealed Preference and Contingent Valuation for the measurement of project impacts that either lack a market price or which can be used to calculate shadow prices, and the unit analyses the strengths and weaknesses of these valuation techniques. It covers cost-effectiveness analysis in situations where project benefits are not measurable and assesses the most appropriate project evaluation techniques for different economic sectors. Finally, it provides a critical review of the advantages and limitations of social cost-benefit analysis.

Unit 5

Unit 5 is about the application of SCBA in transport, water, education, environment and healthcare. It shows how the analysis has been used to make decisions in these sectors and how it can inform the decision-making process.

Units 6

Unit 6 deals with the issues of risk and uncertainty and presents some of the methods of dealing with this aspect of project appraisal. It covers the differ- ent types of risk and uncertainty implicit in projects, and some of the techniques for dealing with risk and uncertainty and their strengths and weaknesses. Risks may include physical (climate, weather, earthquakes and other natural disasters), financial, monetary (foreign exchange movements), planning and security risks. As well as risk, to which a probability of occur- rence may be assigned, there is another element in project appraisal – uncertainty, to which a probability cannot be assigned.

Unit 7

Unit 7 considers some of the important issues associated with the impacts of projects on the distribution of income in country and how SCBA may be used to take these distributional issues into account. When appraisals are

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5 Studying the Course

As you work through the course materials, there are various exercises that are designed to consolidate your knowledge and skills. We recommend that you do the exercises, most of which take half an hour or less, before you look at any model answers that are given in the unit. At certain points we will ask you to reflect on various aspects of the policy process where you work. It will be valuable for you and your fellow stu- dents to share these reflections on the VLE. These short notes setting out the issue and the approach will enrich your and your fellow students’ experi- ence of the course. Please feel free to raise queries with your tutor and with your fellow stu- dents, if there are issues that are not clear to you. Do this as soon as you find a problem, because waiting will hold you up as you work through the course. We hope that you will find the course instructive, useful and occasionally challenging.

6 Assessment

Your performance on each course is assessed through two written assign- ments and one examination. The assignments are written after Week 4 and Week 8 of the course session and the examination is written at a local examin- ation centre in October. The assignment questions contain fairly detailed guidance about what is required. All assignment answers are limited to 2,500 words and are marked using marking guidelines. When you receive your grade it is accompanied by comments on your paper, including advice about how you might im- prove, and any clarifications about matters you may not have understood. These comments are designed to help you master the subject and to improve your skills as you progress through your programme. The written examinations are ‘unseen’ (you will only see the paper in the exam centre) and written by hand, over a three hour period. We advise that you practice writing exams in these conditions as part of you examination preparation, as it is not something you would normally do. You are not allowed to take in books or notes to the exam room. This means that you need to revise thoroughly in preparation for each exam. This is especially important if you have completed the course in the early part of the year, or in a previous year.

Preparing for Assignments and Exams

There is good advice on preparing for assignments and exams and writing them in Sections 8.2 and 8.3 of Studying at a Distance by Talbot. We recom- mend that you follow this advice.

Course Introduction and Overview

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The examinations you will sit are designed to evaluate your knowledge and skills in the subjects you have studied: they are not designed to trick you. If you have studied the course thoroughly, you will pass the exam.

Understanding assessment questions

Examination and assignment questions are set to test different knowledge and skills. Sometimes a question will contain more than one part, each part testing a different aspect of your skills and knowledge. You need to spot the key words to know what is being asked of you. Here we categorise the types of things that are asked for in assignments and exams, and the words used. All the examples are from past examination papers and assignment ques- tions.

Definitions Some questions mainly require you to show that you have learned some concepts, by setting out their precise meaning. Such questions are likely to be preliminary and be supplemented by more analytical questions. Generally ‘Pass marks’ are awarded if the answer only contains definitions. They will contain words such as:
Describe
Define
Examine
Distinguish between
Compare
Contrast
Write notes on
Outline
What is meant by
List

Reasoning Other questions are designed to test your reasoning, by explaining cause and effect. Convincing explanations generally carry additional marks to basic definitions. They will include words such as:
Interpret
Explain
What conditions influence
What are the consequences of
What are the implications of

Judgment Others ask you to make a judgment, perhaps of a policy or of a course of action. They will include words like:
Evaluate
Critically examine
Assess
Do you agree that
To what extent does

Course Introduction and Overview

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70% and above: Distinction As for the (60-69%) below plus:

• shows clear evidence of wide and relevant reading and an engagement with the conceptual issues
• develops a sophisticated and intelligent argument
• shows a rigorous use and a sophisticated understanding of relevant source materials, balancing appropriately between factual detail and key theoretical issues. Materials are evaluated directly and their assumptions and arguments challenged and/or appraised
• shows original thinking and a willingness to take risks

60-69%: Merit As for the (50-59%) below plus:

• shows strong evidence of critical insight and critical thinking
• shows a detailed understanding of the major factual and/or theoretical issues and directly engages with the relevant literature on the topic
• develops a focussed and clear argument and articulates clearly and convincingly a sustained train of logical thought
• shows clear evidence of planning and appropriate choice of sources and methodology

50-59%: Pass below Merit (50% = pass mark)

• shows a reasonable understanding of the major factual and/or theoretical issues involved
• shows evidence of planning and selection from appropriate sources,
• demonstrates some knowledge of the literature
• the text shows, in places, examples of a clear train of thought or argument
• the text is introduced and concludes appropriately

45-49%: Marginal Failure

• shows some awareness and understanding of the factual or theoretical issues, but with little development
• misunderstandings are evident
• shows some evidence of planning, although irrelevant/unrelated material or arguments are included

0-44%: Clear Failure

• fails to answer the question or to develop an argument that relates to the question set
• does not engage with the relevant literature or demonstrate a knowledge of the key issues
• contains clear conceptual or factual errors or misunderstandings [approved by Faculty Learning and Teaching Committee November 2006]

Specimen exam papers

Your final examination will be very similar to the Specimen Exam Paper that is printed at the end of this booklet. It will have the same structure and style and the range of question will be comparable. CeFiMS does not provide past papers or model answers to papers. Our courses are continuously updated and past papers will not be a reliable

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guide to current and future examinations. The specimen exam paper is designed to be relevant to reflect the exam that will be set on the current edition of the course

Further information

The OSC will have documentation and information on each year’s examination registration and administration process. If you still have questions, both academics and administrators are available to answer queries. The Regulations are also available at www.cefims.ac.uk/regulations.shtml, setting out the rules by which exams are governed.

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Engagement Process of interacting with stakeholders to produce better decisions/ outcomes – the level of engagement may increase in level, as follows: inform, consult, involve, collaborate, empower Evaluation An assessment of the efficiency, effectiveness, impact, sustainability and relevance of a project in the context of stated objectives Ex ante appraisal Appraisal carried out before a project is started, based on prediction and extrapolation Ex post evaluation An evaluation of a completed project Externalities Also known as spill-over effects and intangible effects – the impacts of a project on third parties or society in general not captured by markets and therefore market prices Financial analysis The type of investment appraisal carried out by profit-seeking businesses – it involves the evaluation of the prospective costs and revenues generated by an investment in a capital project over its expected life, excluding non- monetary items and externalities Gini coefficient A coefficient based on the Lorenz curve showing the degree of inequality in a frequency distribution such as personal incomes. If the frequency distribution is equal, the Lorenz curve coincides with the 45^0 line Hedonic pricing Hedonic pricing is a method of establishing an economic value for environmental factors such as pollution and environmental degradation; the method uses a surrogate measure such as the impact of pollution on property and land prices, and it assumes that there is specific data on land and property prices which can be assessed against pollution – this is a technique used for calculating revealed preferences (RP) Human capital The technique attempts to measure earnings of individuals to value the impacts of such events as education, health-care, risks of accidents and death – a technique used for calculating revealed preferences (RP) Impact Any change (beneficial or adverse) in the environment (social or biophysical) as a result of human activity Impact analysis A detailed accounting of the environmental, health and social impacts of a project Infrastructure projects Infrastructure projects are normally concerned with the provision of roads, airports, ports, sewage and water systems, railways, telecommunication and other public utilities such as schools, hospitals and clinics; such projects are basic to economic development and improvements in infrastructure may also be used to attract industry and investment to a particular country and or region Integrated assessment Forms of impacts assessment that aim to align/combine a number of established assessment techniques (e.g. Economic Impact Assessment + Social Impact Assessment), and/or to compare/explore interrelationships between themes (e.g. biophysical and social) Internal rate of return (IRR) The discount rate that produces a NPV of zero Investment appraisal The evaluation of the prospective costs and revenues generated by an investment in a capital project over its expected life Kaldor-Hicks compensation test A project or policy should be adopted only if those who gain could fully compensate those who lose and still be better off Life-cycle assessment Compilation and evaluation of the inputs, outputs and the potential environmental impacts of a product system throughout its life cycle

Course Introduction and Overview

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Lorenz curve A graphical representation showing the degree of inequality of a frequency distribution in which the cumulative percentages of a population are plotted against the cumulative percentage of the variable under study (e.g. incomes, employment) Marginal utility of income The extra satisfaction gained by a consumer from a small increment in income Mitigation Measures to prevent/ eliminate, reduce/ minimise, remediate/ repair or compensate adverse impacts Monte Carlo method Method for estimating probabilities – it involves the construction of a model and the simulation of the outcome of an activity a large number of times Net present Value (NPV) The difference between the discounted present value of future benefits and the discounted present value of future costs Opportunity cost of capital The next best alternative return available for the funds in the capital markets Opportunity cost The value of the most valuable of alternative uses Pareto efficiency A position in which it is not possible to make at least one person better off without making anyone worse off. Also known as allocative efficiency Pay Back The period over which the cumulative net revenue from an investment project equals the original investment Present value The discounted value of a financial sum arising at some future period Private costs and benefits The costs incurred and the benefits received by those producers and consumers immediately involved in a project Private rate of return (PRR) The rate of return to an individual or business of some activity or investment – only includes the costs incurred by that individual or business (private costs) and the benefits to that individual or business (private benefits) Production-function methods These methods measure the impact of, for example, pollution, on production and output, and use the market prices of that production/output to value these impacts Problem tree A diagrammatic representation of a negative or potentially negative situation showing a cause and effect relationship Programme A programme includes a number of related but distinct projects Project A series of activities with set objectives to produce a specific outcome within a limited time frame Project cycle The project cycle follows the life of the project from the initial idea through to its completion Public goods Goods that are both non-rivalrous in consumption and no one can be prevented from consuming them (non-excludable) Quality adjusted life years (QALYs) Morbid life years are adjusted by subjective measures of quality where a fully functional year of life is given a weight of 1 and dysfunctional years are counted as fractions Rate of return Net profit after depreciation as a percentage of average capital employed in the business – the rate of return calculation may be made using profit before or after tax Relevant cash flows The cash costs and revenues incurred as a result of an investment Return on capital employed (ROCE) Ratio of accounting profit generated by an investment project to the required capital outlay, expressed as a percentage

Course Introduction and Overview

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Travel cost method (TCM) The value of an environmental location is the time and cost that people take to travel to that location plus the admission charge if there is such a charge Uncertainty A future event or outcome to which no probability of its occurrence can be attached Vulnerable individuals or groups People who are differentially or disproportionately sensitive to change (or in need of change), since they are underrepresented, disadvantaged or lacking in power/ influence/ capacity Weighted average cost of capital (WACC) Investment projects may be financed by debt and/or equity in the private sector – the respective costs of both types of finance are weighted by the proportions used to finance a particular project in order to calculate that project’s cost of capital Welfare/Distributional weights The weighting attached to a particular cost or benefit for a particular project beneficiary Willingness to accept The compensation required to return an individual to his or her original state of economic well-being following some change (possibly hypothetical) in the world Working capital The cash to fund the stock of goods/inputs that a business needs to hold in order to operate Willingness to pay (WTP) The willingness of an individual to pay in order to get a good or services

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UNIVERSITY OF LONDON

Centre for Financial and Management Studies

MSc Examination

Postgraduate Diploma Examination

for External Students

91DFMC

PUBLIC POLICY & MANAGEMENT

PUBLIC FINANCIAL MANAGEMENT

Project Appraisal

Specimen Examination

This is a specimen examination paper designed to show you the type of examination you will have at the end of this course. The number of questions and the structure of the examination will be the same, but the wording and requirements of each question will be different.

The examination must be completed in THREE hours. Answer THREE questions. The examiners give equal weight to each question; therefore, you are advised to distribute your time approximately equally between three questions. You should, where possible, illustrate your answers with references and/or practical examples from the course and from your own experience.

D O NOT REMOVE THIS PAPER FROM THE E XAMINATION ROOM.

IT MUST BE ATTACHED TO YOUR ANSWER BOOK AT THE END OF THE

EXAMINATION.

© University of London, 2013 PLEASE TURN OVER