Appraisal Techniques of Public Investments and Projects

Ministry of Finance and Economic Planning National Development Planning Directorate Public Investment Technical Team Unit Capacity Building to Support the Rwanda Public Investment Program Investment Appraisal Training Manual for Government Staff Prepared by Sulaiman Kyambadde P. O. Box 1851 Kigali, Rwanda Tel: +250 255114413 (office) October 2011 The purpose of this Training Manual is to help PITT implement the use of international best practices of Investment Appraisal techniques in its programming of public sector investments.
It describes how public sector investments should be assessed at conception or programming stage. The modules introduce the basic concepts behind the appraisal techn iques and their applicability in the Rwandan context. It describes the DCF methodology, the shadow pricing methodology and performance measures and decision criteria, together with financial and economic analysis techniques. By their very nature, public projects involve benefits and costs to society over a number of years into the future, unfortunately, market prices and investment outcomes cannot be predicted with certainty.
The manual also introduces qualitative analysis concepts of investments. Author Mr. Sulaiman Kyambadde, is an economist, and a business and development consultant working with PPM Consulting Limited. PPM Consulting is a local management and development consulting firm with headquarters in Kigali, the nation’s capital. In addition, officials from the Ministry of Finance and Economic Planning provided invaluable input on government priorities and requirements to complete the manual. Disclaimer The Training Manual is made possible by the support of PITT management and staff.

The contents of this manual are the sole responsibility of the author and do not necessarily reflect the views of the Ministry of Finance and Economic Planning or the Government of Rwanda. Investment Appraisal Training Manual for Public Projects Investment Appraisal Training Manual Table of contents Author …………………………………………………………………………………………………………………………………. 1 Disclaimer …………………………………………………………………………………………………………………………… Table of contents …………………………………………………………………………………………………………………. 2 1. Overview of the manual ……………………………………………………………………………………………. 4 1. 1 Purpose of the manual ………………………………………………………………………………………………. 4 1. 2 Quality management …………………………………………………………………………………………………. 1. 3 Content ………………………………………………………………………………………………………………………. 5 1. 4 How to use the manual ……………………………………………………………………………………………… 6 2. Module 1: Public investment management ………………………………………………………………. 8 2. 1 Investment cycle management ………………………………………………………………………………….. 2. 2 Planning and management tools ………………………………………………………………………………. 9 2. 3 Government requirements ………………………………………………………………………………………. 12 3. Module 2: Discounted cash flow methodology ………………………………………………………. 21 3. 1 Introduction and overview ……………………………………………………………………………………… 21 3. Cash flows, compounding and discounting concepts ……………………………………………. 21 3. 2. 1 Examples to illustrate the difference between compounding and discounting …….. 22 3. 2. 2 Typical investment considerations ………………………………………………………………………….. 23 3. 3 Defining annual cash flows ……………………………………………………………………………………… 24 3. 4 Performance measures, decision criteria and the issues involved …………………………. 25 3. 4. Net present value …………………………………………………………………………………………………….. 26 3. 4. 2 Net future value……………………………………………………………………………………………………….. 26 3. 4. 3 Internal rate of return ………………………………………………………………………………………………. 26 3. 4. 4 Benefit-to-cost ratios ………………………………………………………………………………………………… 9 3. 4. 5 The payback period …………………………………………………………………………………………………. 30 3. 4. 6 The peak deficit ………………………………………………………………….. …………………………………… 30 3. 5 Review of DCF performance criteria ………………………………………………………………………. 31 4. Module 3: Evaluation methods ……………………………………………………………………………….. 35 4. Introduction and overview ……………………………………………………………………………………… 35 4. 2 Shadow pricing methodology, application and the issues involved ……………………… 35 4. 2. 1 Rationale for use of shadow prices………………………………………………………………………….. 37 4. 2. 2 Determining prices ………………………………………………………………………………………………….. 38 4. 2. 3 Review of the application of shadow pricing methodology …………………………………… 4 4. 2. 4 Limitations of using shadow prices ………………………………………………………………………… 51 4. 2. 5 Best approaches to valuing project benefits and costs ……………………………………………. 52 4. 3 Financial Analysis ……………………………………………………………………………………………………. 57 4. 3. 1 Requirements …………………………………………………………………………………………………………… 58 4. 3. Developing financial cash flows ……………………………………………………………………………… 59 4. 3. 3 Constructing tables of revenues and expenditures ………………………………………………… 61 4. 3. 4 Evaluation Criteria …………………………………………………………………………………………………… 65 4. 3. 5 Illustration of cash flows………………………………………………………………………………………….. 66 PITT Management Resources Page 2 of 176
Investment Appraisal Training Manual for Public Projects 4. 3. 6 Points to note……………………………………………………………………………………………………………. 68 4. 4 Economic analysis ……………………………………………………………………………………………………. 73 4. 4. 1 Underlying differences between economic and financial analysis ………………………… 74 4. 4. 2 Economic approach and elements …………………………………………………………………………… 7 4. 4. 3 Methods of economic analysis ………………………………………………………………………………… 78 4. 4. 4 Process of economic analysis …………………………………………………………………………………… 80 4. 4. 5 Assumptions for economic analysis………………………………………………………………………… 85 4. 4. 6 Developing economic cash flows…………………………………………………………………………….. 86 4. 4. Evaluation criteria ……………………………………………………………………………………………………. 99 4. 5 Cost effectiveness analysis …………………………………………………………………………………….. 100 4. 5. 1 Estimating effectiveness…………………………………………………………………………………………. 101 4. 5. 2 Estimation of costs …………………………………………………………………………………………………. 04 4. 5. 3 Sources of information …………………………………………………………………………………………… 105 4. 5. 4 Evaluation measures and decision parameters …………………………………………………….. 105 4. 5. 5 Methods of cost-effectiveness analysis ………………………………………………………………….. 106 4. 5. 6 Limitations of cost-effectiveness analysis ……………………………………………………………… 111 4. Cost benefit analysis ………………………………………………………………………………………………. 113 4. 6. 1 Input-output model framework…………………………………………………………………………….. 114 4. 6. 2 Measuring and valuing benefits and costs ……………………………………………………………. 114 4. 6. 3 Some important concepts ………………………………………………………………………………………. 115 4. 6. Valuing benefits and costs by market prices …………………………………………………………. 120 4. 6. 5 Consumer surplus and producer surplus as components of value ……………………… 120 4. 6. 6 Developing cash flows …………………………………………………………………………………………… 127 4. 6. 7 Evaluation criteria ………………………………………………………………………………………………….. 129 4. 6. 8 Limitations of cost-benefit analysis ……………………………………………………………………….. 30 4. 7 Sensitivity analysis …………………………………………………………………………………………………. 131 4. 7. 1 Types of sensitivity analysis ………………………………………………………………………………….. 133 4. 7. 2 How to conduct sensitivity analysis ……………………………………………………………………… 141 4. 7. 3 Importance of sensitivity analysis …………………………………………………………………………. 145 4. 7. Sensitivity and decision making ……………………………………………………………………………. 147 4. 7. 5 Determinants of sensitivity and common project risks ………………………………………… 148 4. 7. 6 General approaches to uncertainty and risk …………………………………………………………. 149 4. 7. 7 Decision making when dealing with uncertainty and risk …………………………………… 153 4. 7. 8 Risk preferences in the public sector……………………………………………………………………… 154 4. 7. Limitations of sensitivity and risk analysis …………………………………………………………… 154 Appendices……………………………………………………………………………………………………………………… 156 Example I: Conversion factors for major transport projects in southern Italian regions …………… 156 Example II: Conversion factors for projects in South Africa…………………………………………………… 156 Case study I: Czeck Republic_Cycling Infrastructure Network in Pilsen ……………………………….. 57 Case study II: India_Rural Road Project ………………………………………………………………………………. 161 Case study III: Cambodia_Health Project …………………………………………………………………………….. 165 Glossary…………………………………………………………………………………………………………………………….. 170 References …………………………………………………………………………………………………………………………. 174
PITT Management Resources Page 3 of 176 Investment Appraisal Training Manual for Public Projects 1. Overview of the manual The National Public Investment Policy adopted by the cabinet on February 10, 2009 outlines the necessary organizational structures, analytical tools and decision-making processes that enable staff to manage public investments in the country. However, the capacity gap assessment conducted in mid 2011 revealed the lack of analytical skills at different levels of the program scale, including; financial and economic analysis, cost-benefit analysis and project cycle management.
At the same time, the government needs trained staff that have the capacity to appraise investments and make better informed decisions on a structured and accountable basis with respect to public finances. Subsequently, this capacity must be developed and institutionalized into the mainstream of government practices to ensure sustainability of the effort. 1. 1 Purpose of the manual This training manual is aimed primarily at trainers, government staff (working with ministries, public agencies local government entities), and others involved in PIP/PPP program management.
It also serves as a desk reference and as a post-training support to the application of techniques learnt during training. The objectives of this manual thus reflect those of the capacity building effort itself. By the end of the training workshop, trainees will understand: • The role of PIP development, information needs and key activities to be undertaken at each decision gate. • The basic concepts of the discounting cash flow methodology and its application when assessing investments. •
The basic concepts of the shadow pricing methodology and its application when evaluating investments. PITT Management Resources Page 4 of 176 Investment Appraisal Training Manual for Public Projects • How to use multiple techniques to assess public investments, in particular; financial, economic and cost-benefit analysis. • The importance of the integrated approach and reality checks. 1. 2 Quality management At strategic level, investment planning and programming is undertaken by PITT staff or consultants or PITT staff and partner organizations.
While at tactical level, investment conception, planning and appraisal is undertaken by staff from line ministries and decentralized local governments. The role of PITT staff is to coordinate the process of investment preparation and appraisal while managing the process of programming. Line ministries and local governments are responsible for the conception and appraisal (including management of feasibility studies) of projects following methodologies laid down by the Public Investment Technical Team Unit.
Then, PITT appraises the feasibility studies, ranks and selects among project ideas, and incorporates them into the public investment program. As process managers at either level, they therefore need tools and techniques which help them to support and control the quality of outputs produced during the process – for example, to identify information needs, to quantify and/or verify benefit and cost estimates, to review strategy and plan further appraisals; to check the quality of investment proposals; and to program investments. This process is key to managing quality. 1. Content The techniques delineated in the manual are designed to assist in preparing for training workshops as well as to assess public investments when appropriate: Module 1 introduces the national priorities, PIP management, project selection and investment decision criteria. Module 2 introduces the DCF methodology, explains its role in investment appraisal and describes how cash flows are derived. It also presents the overview of investment appraisal decision criteria. PITT Management Resources Page 5 of 176 Investment Appraisal Training Manual for Public Projects
Module 3 introduces the shadow pricing methodology, explains how it is used to quantify benefits and costs of specific investment types at project and national levels. It also presents the basic concepts and detailed application of financial, economic and cost-benefit analysis techniques, and the role of every technique in investment appraisal. 1. 4 How to use the manual Each module begins by introducing the basic concepts and contemporary issues. Major points are outlined and relevant details on the applications are provided.
During the training, trainees should use the manual as a reference to deepen their understanding of the techniques, issues and concerns raised. Trainees can develop their own notes and observations for each module. The manual will also act as a useful reminder after training, by helping to apply what was learned. This is a training manual, not a procedures manual. Therefore, it does not address policy, strategy and management issues particular to PIP/PPP program management. It presents the basic concepts and provides techniques that will help to more effectively apply them in investment appraisal tasks.
As there are differences between investment management in how issues are dealt with, practice of the investment appraisal techniques will have to be modified to suit the particular circumstances of the operating environment. Investment appraisal practice follows an evolutionary approach, and new tools could be developed in response to operational requirements or lessons learned. Hence, techniques presented here should be seen as flexible and open to linkage with other management tools. Equally, the manual reflects the current training requirements of government staff.
As these requirements evolve, so the manual will be modified to meet these needs. The manual is therefore seen as a resource that will be managed to meet these changing needs. PITT Management Resources Page 6 of 176 Investment Appraisal Training Manual for Public Projects Requirements for implementation of the manual • Understanding of the basic concepts of welfare economics. • Adequate resourcing of the data collection exercise in order to allow the analyst acquire the information necessary for performing economic analysis. Development of national guidelines on shadow pricing to avoid abuse of shadow prices and the methodology at project level. • Development of PIP project management implementation manual to ensure uniform application across the board. Comments on contents, best practices and/or case studies are welcome, and should be addressed to the Coordinator of PITT. PITT Management Resources Page 7 of 176 Investment Appraisal Training Manual for Public Projects 2. Module 1: Public investment management
The administration of public investments is under the armpit of the PITT, and is managed under the National Public Investment Policy, consistent with the Rwanda Aid Policy guidelines as well. The national public investment policy was adopted by the cabinet on February 10, 2009. The national public investment policy objective is five-fold, namely to ensure: • Alignment of public and private investment to the national medium and long term development goals; • Quality, in terms of efficiency and efficacy, of the investment portfolio and increased level of project execution rates; Increased coordination between public and private investment, including Public Private Partnerships; • Sufficient resources are allocated to the public investment program; and • Public resources are optimally leveraged to attract private investment. 2. 1 Investment cycle management Generally, the investment cycle must be consistent with the national budget cycle. In order to harmonize the Rwanda’s budget cycle with the other member states of the East African Community, the budget cycle runs from July to June of each year.
As part of the larger public reforms, the budget cycle is to help government take stock of: the extent of its multi-year fiscal planning, expenditure policy making and budgeting; organization and participation in the budget formulation process; coordination of the budgeting of recurrent and investment expenditures; and scrutiny of the annual budget law. PIP programming is grounded on the imperatives of Vision 2020, EDPRS and MDGs, and is subject to the Medium Term Expenditure Framework (MTEF) guidelines. Like PIP, MTEF is a three-year rolling plan that takes into account the country’s needs, priorities and absorption capacity.
MTEF was put in place in order to improve on budgetary discipline. MTEF is a PITT Management Resources Page 8 of 176 Investment Appraisal Training Manual for Public Projects supplement and not a substitute of PIP, it is simply a more ambitious and comprehensive scheme. In principle, it links policy-making, planning and budgeting, in so doing allows expenditures to be driven by policy priorities and disciplined by budget realities. It injects a medium term perspective into the budget process and allows for policy choices that enhance long term development.
Like PIP, MTEF is a rolling budget that covers the current budget year and the next two budget years. It contains a macroeconomic framework with a forecast of revenues and expenditures in the medium term, a multi-year sector program with cost estimates, a strategic expenditure framework, a plan for allocating resources among sectors and detailed sectoral budgets. According to the national planning, budgeting and MTEF guidelines of 2008, the annual budgeting processing should be completed within ten months following approval of the new budget by parliament.
It starts with a reflection on national priorities based on previous year’s performance (3 months), followed by a reflection on the national MTEF and a review of expenditure allocations to sectors and budget agencies (3 months), followed by the preparation of budget proposals by relevant budget agencies in consultation with MINECOFIN (3 months), and ends with the review and submission of the national budget proposal to parliament for approval (1 month). 2. 2 Planning and management tools The Public Investment Technical Team (PITT) is responsible synthesizing investment information, analyzing and programming public investments.
It is also responsible for providing information, strategic research and the necessary advocacy to ensure that government takes the lead role in public investment identification and prioritization. In the conduct of its responsibilities, PITT works closely with line ministries, provinces and districts. PITT is both a user and custodian of information pertaining to public investments in PITT Management Resources Page 9 of 176 Investment Appraisal Training Manual for Public Projects the country.
It provides technical support (advisory services) to line ministries, provinces and district contact staff (persons) in the public investment realm. 2. 2. 1 Planning According to PITT reports, its basic mission is to prepare the Public Investment Program (PIP) in every fiscal year. PIP is a 3 year rolling plan, only the first year is incorporated into the national annual budget. In consultation with other departments of the Ministry of Finance and Economic Planning, and line ministries, it determines which projects are included in PIP and programs the corresponding expenditures and financing flows.
PIP programming must be in alignment with Rwanda’s development goals and objectives, but subject to the country’s fiscal constraints. At the planning stage, PITT undertakes the following tasks: a) Evaluation of the existing PIP’s contribution to attainment of national development goals and objectives. b) Determination of the extent of divergences, in terms of size and structure of expenditure, of existing PIP from what is appropriate. PITT provides recommendations for the realignment of new projects to the PIP, and may, if need be, recommend the reprogramming of on-going and new projects. ) Monitoring the performance of the current PIP. The lessons learned are then used in the formulation of new PIP. d) Ranking and selection of projects to be part of PIP. 2. 2. 2 Project selection criteria In the normal course of doing business, projects are screened and ranked based on their contribution to EDPRS, job creation, export promotion, and presidential promises. On-going projects are accorded priority over new projects because financial commitments have already been made and spending has occurred, and at this stage government priority is towards project completion.
PITT Management Resources Page 10 of 176 Investment Appraisal Training Manual for Public Projects Projects are grouped into 10 sectors, categorized in four clusters. The clusters are; 1) infrastructure sector, 2) productive capacities sector, 3) human development and social sector, and 4) governance and sovereignty sector. The GoR acknowledges the importance of public investment in stabilizing two key macroeconomic variables, trade balance (by promoting export initiatives) and public deficit (reducing the debt burden).
As a result, three major criteria for prioritizing projects that would have an impact on different aspects of the economy are considered, namely: • Desirability, how well does the proposed project fit into government policy priorities, in terms of strategic importance in accordance with the goals set in key national policy documents (EDPRS, Vision 2020 and other policy documents). The proposed project’s impact on poverty and long term transformation of the Rwandan economy, the level of risk associated with the project, and impact on gender inequalities; •
Achievability, how easily can the proposed project be implemented. For example, in terms of securing the site, planning consent and access, and securing the required funding; • Viability, in terms of the likely economic return, as measured by the economic impact assessment and cost-benefit analysis, the project’s impact on the balance of payments, jobs, private investment and GoR’s fiscal position. 2. 2. 3 Management The Public Investment Technical Team (PITT) is responsible for managing the public investment program, under the Ministry of Finance and Economic Planning.
PITT is one of the units under the National Development Planning and Research Department (NDPR). It was placed under the Ministry of Finance and Economic Planning to help ensure that all public investments are of quality and are oriented towards the GoR’s long and medium term goals. PITT is led by a coordinator, supported by eight (8) full-time staff, all under the supervision of NDPR General Director as presented in the organizational structure. PITT Management Resources Page 11 of 176 Investment Appraisal Training Manual for Public Projects
National Development Planning & Research Directorate Public Investment Technical Team Policy Development, Evaluation and Research EDPRS Coordination Investor specialists/ Public Investment Specialists Experts in Policy Analysis EDPRS facilitators Source: PITT 2. 3 Government requirements Rising from a tragic past, Rwanda is on a historic journey to become one of the most dynamic and growth-oriented countries in the world. The public expenditure program has played a crucial role in promoting the socio-economic reconstruction of the country.
Nevertheless, government is intent on improving both public and private investments necessary to meet the nation’s medium term and long term development objectives, as stipulated in the Economic Development and Poverty Reduction Strategy (EDPRS) and Vision 2020. Public investments together with Public Private Partnerships (PPPs) projects and private investments are expected to facilitate the achievement of the nation’s development goals. Although government cannot directly control the level of private investment, authorities recognize that it must provide an enabling environment within which they can thrive.
Regardless, public investment has a central role to play mostly for two reasons: first, through the creation of wealth itself, and second, as a stimulus to private investment-through its capacity to facilitate the creation of wealth by the private sector. On the other hand, private investment (including Public Private Partnerships), are also pivotal instruments mainly for three reasons: first, in accelerating the delivery of strategic national infrastructure; second, achieving the required efficiency (facilitating the achievement of value PITT Management Resources Page 12 of 176
Investment Appraisal Training Manual for Public Projects for money in the long term); and lastly, facilitating the delivery of quality public services without increasing the size of the nation’s sovereign debt. With the above in mind, the GoR developed the National Public Investment Policy under the auspices of the Ministry of Finance and Economic Planning, which was subsequently adopted by the cabinet of ministers in February 2009. The policy acknowledges the role of the private sector as prior noted, promotion of private investment is the responsibility of the Rwanda Development Board.
RDB is a public authority mandated to lead government efforts to fast track country’s economic development. It is responsible for creating a world-class business climate that will build on national assets, expand the private sector, create jobs, and increase opportunities for all Rwandans. 2. 3. 1 National priorities Rwanda’s priorities are defined in the key national policy documents (Vision 2020, EDPRS and the National Public Investment Policy) 1. These national priorities are however, usually reviewed, reaffirmed and/or updated annually by the GoR through the Cabinet.
These updates are for the most part based on national strategies, including the EDPRS and current government priorities. The process of updating priorities at national and sector levels is informed by performance assessment results of the previous year, which takes place at sector and district level during joint reviews with the country’s external financing partners, as well as EDPRS Annual Progress Report (APR). Vision 2020 Vision 2020 is a result of a national consultative process conducted between 1997 and 2000.
Rwandans of all categories including the leadership of all levels in the business community, government, academia and civil society participated in the process. Therefore, Vision 2020 is 1 Refer to the Republic of Rwanda reports and policies for details PITT Management Resources Page 13 of 176 Investment Appraisal Training Manual for Public Projects not only for government, but it is a shared purpose for all Rwandans. It constitutes a bond that holds Rwandans as a people determined to build a better future.
The Vision stipulates six pillars upon which the country’s future is forged, these include: a) Reconstruction of the nation and its social capital anchored on good governance, underpinned by a functional government and capable state; b) Transformation of agriculture into a productive, high value and market oriented sector, with forward linkages to other sectors; c) Development of an efficient private sector propelled by competitiveness and entrepreneurship; d) Comprehensive human resources development, encompassing education, health, and ICT skills, aimed at public and private sectors and the civic society.
To be integrated with demographic, health and gender issues; e) Infrastructural development, entailing improved transport links, energy and water supplies and ICT networks; and f) Promotion of regional economic integration and cooperation. These pillars have to mirror trends in other national cross-cutting issues, including; gender equality, sustainable environmental and natural resource management, and ICT. Economic Development and Poverty Reduction Strategy (EDPRS) Upon review of the last PRSP, the EDPRS identifies the following four priorities for national development. ) Increase economic growth, by investing in infrastructure, promoting skills development and the service sector, and mainstreaming private sector development and modernizing agriculture; b) Slowdown population growth, through reducing infant mortality, promoting family planning and education outreach programs, improving the quality of healthcare and schooling; PITT Management Resources Page 14 of 176 Investment Appraisal Training Manual for Public Projects c) Tackle extreme poverty, through improved food security and targeted schemes for job creation and social protection.
Special focus is on the creation of new employment opportunities, particularly for the youth just entering the labor market; and d) Ensure greater efficiency in poverty reduction, through better policy implementation, including; enhanced coordination among sectors and between levels of government, sharper prioritization of activities, better targeting of services for the poor, widespread mobilization of the private sector, and more effective use of monitoring and evaluation mechanisms.
The EDPRS somewhat mirrors both Vision 2020 and the United Nations Millennium Development Goals (MDGs), though targets for these policies are set for 2020 and 2015 respectively. EDPRS is a 5-year medium term development plan, that is, the EDPRS is a mechanism for implementing the Rwanda Vision 2020 in the medium term. Public and private investments are required to achieve the EDPRS.
Hence it mandates organization of public expenditure in order to maintain momentum in social sectors while targeting productive sectors to achieve the MDGs and Vision 2020 objectives and targets, and the mobilization of private investment for the same purpose as well. Public expenditure is targeted to: address skills shortages; eliminate the infrastructure backlog (including energy, water, transport, and ICT) to reduce the operational costs of doing business in Rwanda; create the conditions under which science and technology ave the way towards knowledge-based services, employment and poverty reduction; widen and strengthen the financial sector; and improve governance at all levels of government and the community. The EDPRS is estimated to cost about RWF 5,151 billion over the five years, between 2008 and 2012. The cost includes public recurrent expenditure, public capital expenditure and private PITT Management Resources Page 15 of 176 Investment Appraisal Training Manual for Public Projects investments. The public component amounts to RWF 3,434 billion (67% of the total cost), the gap is expected to be narrowed by private investments 2.
Millennium Development Goals As reflected in Vision 2020 and the EDPRS, the government has expressed its commitment to achieving the Millennium Development Goals. Both policy documents mirror the MDGs. The MDGs are a set of eight development goals inherent in the Millennium Declaration adopted in September 2000 by Member States of the United Nations. These goals strive to: • Eradicate extreme poverty and hunger; • Achieve universal primary education; • Promote gender equality and empower women; • Reduce child mortality; • Improve maternal health; •
Combat HIV/AIDS, malaria and other diseases; • Ensure environmental sustainability; and • Develop a global partnership for development. Rwanda’s rationale for investing in MDGs The rationale for GoR to invest in the MDGs and the impetus for involving local governments include the following: • MDG 1 Eradicating extreme poverty and hunger; prudent poverty alleviation, employment creation and food production efforts need to be based on local realities and initiatives, and require the participation of and ownership by local governments and communities. •
MDGs 2, 4, 5, and 6 Service delivery for education, health and sanitation; establishing and maintaining local mechanisms for primary healthcare, education and basic 2 Refer to EDPRS document for details. PITT Management Resources Page 16 of 176 Investment Appraisal Training Manual for Public Projects infrastructure are the main responsibility of and/or are better managed by decentralized local governments, as long as they are adequately funded and well equipped to perform. • MDG 3 Gender empowerment; women are vehicles of change in their households and communities.
Therefore, investing in efforts that directly target women and children, such as primary healthcare, clean water, schools and sustainable agricultural practices can immediately improve the livelihood of everyone. Also, it is believed that empowering women at the local level leads to better educated and nourished children, better management of natural resources and promotes local ownership of development results. • MDG 7 Ensuring environment sustainability; addressing climate change and environmental sustainability requires community adaptation without compromising the means to earn their living.
Hence, community adaptation and mitigation efforts to minimize the negative effects of climate change are effective when implemented at the local level. All public investments in MDGs, whether for employment creation through sustainable agricultural practices, schools and households, can greatly benefit efforts to preserve the environment and protect ecosystems. • MDG 8 Develop a global partnership for development; developing local capacity is essential for ensuring sustainability of efforts supported by the central government and its development partners.
Partnership becomes a reality by delivering basic services at the local level. Government staff, service delivery officials, civil society organizations and private investors working together is the key to ensuring buy-in and sustainability of local development processes. It has been proven that while governments are catalysts, local actors (communities, the private sector, and non-government organizations) are also crucial in the achievement of the MDGs. However, successful local partnerships and interventions require balancing in both scale and support in order to make a sizeable and sustained impact.
Scaling up must go beyond PITT Management Resources Page 17 of 176 Investment Appraisal Training Manual for Public Projects increasing fund allocations for service delivery, it is also necessary to government to provide capacity development support to strengthen local actors. This involves understanding what works at the local or community level and why. Rwanda Aid Policy The aid policy of 2006 is a child of the realization that the GoR lacked clear structures and guidelines for the mobilisation and management of external assistance.
This policy is seen as a vehicle for improving the effectiveness of assistance the country receives and increasing the mobilization of assistance at the same time. Improving aid effectiveness in particular, is expected to equally improve service delivery to Rwandans while accelerating the implementation of EDPRS. Also, the GoR acknowledges five core issues imperative for effective external assistance management and in tackling the development challenges the country is grappling with in the long run. At the end of the day, external assistance can only support but not supplant local processes. •
The necessity of good governance; no volume of external assistance can stimulate sustainable growth without a stable and supportive social political and economic climate. • Need for long term planning; the Government is committed to promoting long term development of the economy with attention to poverty reduction, job creation and other opportunities. • Partnership with the private sector in the fight against poverty; the GoR’s medium objectives as outlined in the EDPRS will be achieved through private sector development, supported by government, sound trade practices and a stable macroeconomic environment. Need for public sector reforms; public sector reforms would ensure the country builds efficient and effective organisations ready for the development challenges in the long run. Continuous review of organisational objectives and structures will facilitate the PITT Management Resources Page 18 of 176 Investment Appraisal Training Manual for Public Projects definition of the roles and responsibilities of civil servants in a way that meets Rwanda’s current and future needs. •
Service delivery is better managed by local actors; the GoR is committed to pursuing the decentralization policy, transferring power, responsibilities and resources to local governments, this is expected to increase local ownership of development activities and sustainability of project outcomes. Rationale for public investment programming The Public Investment Program (PIP) is an economic programming tool that aims to fit resources into the overall public expenditures and development plans. PIP programming is important for the following six principal reasons: • Interpretation of the country’s medium term policies and priorities; Allows PITT scrutiny of project quality, consistency with government policies and priorities, and alignment with the budgeting of available resources; • Informs government of annual project costs, along with the balance of funds required to complete them, and hence affording relevant officials to mobilize resources in time to avoid project delays; • Develops debate between PITT, line ministries and decentralized entities on the suitability of projects, government priorities and objectives. It opens up a communication channel for relevant parties to reflect on sectoral priorities; Maintains fiscal discipline at all levels of government. It ensures that: the first year (segment included in the annual development budget) includes only projects for which the financing has already been committed or is under advanced stages of being secured; the second year includes projects for which the financing has clearly been identified; and the third year holds projects for which the financing is probable but the source has not yet been identified. Overall, it ensures that the first year is consistent with the proposed budget; and PITT Management Resources Page 19 of 176
Investment Appraisal Training Manual for Public Projects • Identifies sound estimates of forward costs of projects (year 2 and 3) and ensures financing needs are compatible with the country’s medium term fiscal framework. These estimates are not easy, but they are essential. PIP includes investments by the central government, investments by public authorities that are financed fully or partly by the central government, and investments that are financed fully or partly by development partners as well. It also, covers investments of public enterprises and/or local governments that are not financed by the central government.
It does not however, cover private investments financed by private enterprises involved in public-private partnerships (projects partially financed by government and private investors). Overall, the national investment policy document acknowledges the role of and encourages private investments in the quest of developing the country. The government will continue to play a leading role in the development of critical infrastructure and in the provision of services where there’s a perceived high risk by private investors. PITT Management Resources Page 20 of 176 Investment Appraisal Training Manual for Public Projects . Module 2: Discounted cash flow methodology 3. 1 Introduction and overview This module introduces the DCF methodology, explains its role in investment appraisal, and describes how cash flows are derived. It also presents the overview of investment appraisal decision criteria. Analysis of investment projects is typically carried out using the technique of discounted cash flow (DCF) analysis, which recognizes that money has a time value. It is therefore, paramount to introduce its concepts before proceeding to topics that deal with financial and economic analysis.
DCF analysis is used to derive investment performance criteria such as net present value (NPV) and internal rate of return (IRR) for example, these are key components to investment performance criteria and the subsequent decision making process. DCF analysis assumes that all cash flows are used, and takes into account the timing of cash flow. Nonetheless it has its shortfalls, including; the difficulty in ascertaining the cost of capital rate or rate of return, which may also vary over the life of the investment/project, and the meaning of some measures (i. e. net present value) are not always clear to users of the information.
Indeed, the survey by the International Federation of Accountants (2008) established that the key challenge in using DCF arises from the confusion that often occurs in understanding its theoretical basis and practical applications. 3. 2 Cash flows, compounding and discounting concepts Cash flow analysis is simply the process of identifying and categorizing a proposed investment or project and making estimates of its value. For example, when the government is considering to establish a new forest plantation, the analyst would identify and make estimates of the cash outflows associated with establishing the trees (i. e. he cost of buying or leasing land, purchasing and planting seedlings), maintaining the plantation (i. e. the cost of fertilizers, labor, pruning and thinning) and harvesting the trees. Likewise, it is necessary to estimate the cash inflows associated with the selling of trees and other products at harvest. PITT Management Resources Page 21 of 176 Investment Appraisal Training Manual for Public Projects The generic discounting cash flow methodology has four stages: 1) projecting revenues (benefits), 2) estimating capital expenditure (investments) and costs of maintaining operations, 3) determining cash flows, and 4) estimating discount rate.
Discounted cash flow analysis is an extension of simple cash flow analysis, unlike the latter, it takes into account the time value of money as well as the risks of investing in the project or realization of cash flows. A number of criteria are used in DCF to estimate performance including NPV, IRR and Benefit-Cost ratios (BCR). Before dealing with the criteria to measure project performance, it is necessary to introduce the concepts and procedures behind compounding and discounting. To begin with, look at the concept of simple and compound interest. For the moment, consider the interest rate as the cost of capital for the project. . 2. 1 Examples to illustrate the difference between compounding and discounting Suppose a person has to choose between receiving RWF 1,000 now, or is guaranteed the same amount in 12 months time. A rational person will naturally choose the former, because s/he could use the RWF 1,000 for profitable investment (i. e. deposit the money in the bank and earn interest) or use it for desired consumption during the intervening period. Let us assume that the RWF 1,000 is invested at an annual interest rate of 8%, then over the year it would earn RWF 80 in interest.
That is, a principal of RWF 1,000 invested for one year at an interest rate of 8% would have a future value of RWF 1,000 (1. 08) or RWF 1,080. Likewise, RWF 1,000 may be invested for a second year, in which case it will earn further interest. If the interest again accrues on the principal of RWF 1,000 only, it is known as simple interest. In this case the future value after two years will be RWF 1,160. On the other hand, if interest in the second year accrues on the whole RWF 1,080, known as compound interest, the future value will be RWF 1,080 (1. 08) or RWF 1,166. 40. Most investment and borrowing PITT Management Resources
Page 22 of 176 Investment Appraisal Training Manual for Public Projects situations involve compound interest, although the timing of interest payments may be such that all interest is paid before further interest accrues. The future value of the RWF 1,000 after two years may also be derived as RWF 1,000 (1. 08)2 = RWF 1,166. 40. In general, the future value of an amount RWF x, invested for n years at an interest rate of i, is RWF x times (1+i)n; where x represents the amount involved and i is the interest rate, the interest rate can be expressed in decimal points or as a percentage. Discounting is the reverse of compounding, i. . finding the present-day equivalent to a future sum. Recall in the prior example, we established RWF 1,000 invested for one year at an interest rate of 8% would have a value of RWF 1,080 in one year, therefore the present value of RWF 1,080 one year from now, when the interest rate is 8%, is RWF 1080/1. 08 = RWF 1000. Similarly, the present value of RWF 1,000 to be received one year from now, when the interest rate is 8%, is RWF 1,000/1. 08 = RWF 925. 93 In general, if an amount RWF x is to be received after n years, and the annual interest rate is i, then the present value is RWF x / (1+i)n 3. 2. Typical investment considerations In the two prior examples, discussions have been in terms of amounts in a single year. Investments usually incur costs and generate income in each of a number of years. Suppose the amount of RWF 1,000 is to be received at the end of each of the next four years. If not discounted, the sum of these amounts would be RWF 4,000. But let us suppose the interest rate is 8%. What is the present value of this stream of amounts? This is obtained by discounting the amount at the end of each year by the appropriate discount factor then summing: RWF 1,000/1. 08 + RWF 1,000/1. 82 + RWF 1,000/1. 083 + RWF 1,000/1. 084 = RWF 1,000/1. 08 + RWF 1,000/1. 1664 + RWF 1,000/1. 2597 + RWF 1,000/1. 3605 PITT Management Resources Page 23 of 176 Investment Appraisal Training Manual for Public Projects = RWF 925. 93 + RWF 857. 34 + RWF 793. 83 + RWF 735. 03 = RWF 3,312. 13 The discount factors, 1/1. 08t for t = 1 to 4, may be calculated for each year or read from published discounting tables or derived using MS excel functions. It is to be noted that the present value of the annual amounts is progressively reduced for each year further into the future (from RWF 925. 93 after one year to RWF 735. 3 after four years). 3. 3 Defining annual cash flows Typical projects result into the creation of an asset (i. e. forestry plantation, road, plant etc). Therefore, any project may be regarded as generating cash flows. The term cash flow refers to any movement of money to or away from the project sponsor or investor (government, or an individual, company, industry etc). Projects require payments in the form of capital outlays and annual operating costs or cash outflows, which we could refer to as project costs. They give rise to receipts or revenues or cash inflows, referred to as project benefits.
For each year, the difference between project benefits and capital plus operating costs is known as the net cash flow for that year. The net cash flow in any year may be defined as NCF = bt – (kt + ct), where; bt are project benefits in year t, kt are capital outlays in year t and ct are operating costs in year t. Take note that when determining these net cash flows, expenditure items and income items are timed for the point at which the transactions take place, rather than the time at which they are used. For example, expenditure on purchase of machinery rather than annual allowances for depreciation would enter the cash flows.
It is also advisable that cash flows should not include interest payments. The discounting procedure in a sense simulates interest payments, so to include these in the operating costs would be to double-count them. PITT Management Resources Page 24 of 176 Investment Appraisal Training Manual for Public Projects Hypothetical illustration A project involves an immediate outlay of RWF 25,000, with annual expenditures in each of three years of RWF 4,000, and generates revenue in each of three years of RWF 15,000. The annual cash flow for would therefore, be derived as follows: Year 0 1 3 Benefits (RWF) 15,000 15,000 15,000 Capital outlay (RWF) 25000 – Costs (RWF) 2,000 4,000 4,000 2,000 Net cash flow (NCF) RWF -27,000 11,000 11,000 13,000 Take note of two points. First, the capital outlay is timed for Year 0. By convention this is the beginning of the first year (i. e. right now). On the other hand, only half of the first year’s operating costs are scheduled for the Year 0 (the beginning of the first year). The remaining half of the first year’s operating costs plus the first half of the second year’s operating costs are scheduled for the end of the first year.
In this way, operating costs are spread equally between the beginning and the end of each year. But in the case of project benefits, these are assumed to accrue at the end of each year, which would be consistent with lags in production or payments. These within-year timing issues are unlikely to have significant impact on the overall project profitability, but it is useful to make these timing assumptions clear. Second, net cash flows (second column less third plus fourth column) are at first negative, but then become positive and increase over time.
This is a typical pattern of well-behaved cash flows, for which performance criteria can usually be derived without computational difficulties. 3. 4 Performance measures, decision criteria and the issues involved Decision making on investment or project selection and resource allocation is based on approved criteria. Take note that the Rwanda National Public Investment Policy pronounces NPV and IRR, but does not specify the magnitude of these parameters (threshold). PITT Management Resources Page 25 of 176 Investment Appraisal Training Manual for Public Projects
With that in mind, let us now consider a number of project performance criteria which can be obtained by discounted cash flow analysis. These criteria will be defined, then derived for the cash flow data of our hypothetical illustration. 3. 4. 1 Net present value The net present value (NPV) is the sum of the discounted annual cash flows. NPV is derived by use of the following formula; NPV = x0 + x1/(1+i) + x2/(1+i)2 + x3/(1+i)3 A project is regarded as economically desirable if the NPV is positive. This means that the project can bear the cost of capital (the interest rate) and still leave a surplus or profit.
For the example, if we are to take 8% as our interest rate. NPV = -27,000 + 11,000/(1. 08) + 11,000/(1. 08)2 + 13,000/(1. 08)3 = -27,000 + 11,000/1. 1664 + 11,000/1. 2597 + 13,000/1. 3605 = RWF 2,935. 73 The interpretation of this figure is that the project can support an 8% interest rate and still generate a surplus of benefits over costs, after allowing for timing differences in these, of approximately RWF 2,936. 3. 4. 2 Net future value As earlier established, an alternative to the net present value is the net future value (NFV), for which annual cash flows are compounded forward to their value at the end of the project’s life.
Once the NPV is known, the NFV may be obtained indirectly by compounding forward the NPV by the number of years of the project life. Using the same illustration, the net future value is NFV = NPV (1. 08)3 = RWF 2,935. 73 x 1. 3605 = 3,994. 06. 3. 4. 3 Internal rate of return The internal rate of return (IRR) is the interest rate that makes the sum of discounted net cash flows zero. If the interest rate were equal to the IRR, the net present value would be exactly zero. Take note, the IRR cannot be determined by an algebraic formula, but rather has to be PITT Management Resources Page 26 of 176
Investment Appraisal Training Manual for Public Projects approximated by trial and error methods. Continuing with our illustration, we know that the IRR is somewhere above 8%. Deriving the NPV with a range of discount rates would reveal that the IRR falls between 13% and 14%, but closer to the latter. In practice, a financial function can be called up to perform the trial-and-error calculations. It would be found in this case that the IRR is about 13. 8%. Take note, calculation of internal rate of return in fact involves solving a polynomial equation, and efficient solution methods such as Newton’s approximation are used in computer packages.
The IRR can also be defined as the highest interest rate which the project can support and still break even. Therefore, in economic terms, a project is judged to be worthwhile if IRR is greater than the cost of capital. In this case, our hypothetical project can support a rate of interest that is higher than 8%, and still make a positive payoff. In other words, the project would be profitable provided the cost of capital was less than 13. 8%. However, the IRR as a criterion of project profitability suffers from a number of theoretical and practical limitations.
On the theoretical side, it assumes that the same rate of return is appropriate when the project is in surplus and when it is in deficit. However, the cost of borrowed funds may be quite different to the earning rate of the company. In that case, it could be more appropriate to use two rates when determining the IRR. The actual cost of capital could be used when the project is in deficit, and the earning rate (unknown, to be determined by trial and error) could be applied when the project is in surplus. This would give a better indication of the earning rate of the project to the company or government.
From a practical viewpoint, the IRR may not exist or it may not be unique. Consider a project for which the net cash flow in each year (including Year 0) is positive. Regardless of the interest rate, the NPV will never be zero, so it will not be possible to determine an IRR. Similarly, a project with a large initial capital outlay and for which future benefits are PITT Management Resources Page 27 of 176 Investment Appraisal Training Manual for Public Projects relatively small or negative may not have a positive NPV regardless. Hence, the curve for the NPV profile may never cross the interest axis.
In the same vein, if a project generates runs of positive and negative net cash flows, this will generate multiple IRRs. Take note, mathematically, the polynomial equation defining the NPV can have as many roots/solutions as there are turning points in NPV values (changes from positive to negative or negative to positive). A project which has alternating runs of positive and negative cash flows is a candidate for problems with estimation of the IRR. This indicates multiple internal rates of return, one at each interest rate where NPV is zero.
It is then by no means clear which if any of the rates we should choose to call the IRR. In addition, when the NPV is properly profiled in these kind of situations, it could be determined that NPV is increasing as the interest rate increases, which would imply that the greater the cost of capital the more profitable the project, this is exemplified by the NPV profile exhibit below. Clearly, multiple internal rates of return and perverse relationships between the NPV and the discount rate are not very satisfactory. NPV profile exhibit shows the presence of multiple IRRs in a project, IRR is 10. 1% and 42. 66% respectively. NPV (000’s) RWF 4,000 RWF 2,000 RWF 0 0 0. 05 0. 1 0. 15 0. 2 0. 25 0. 3 0. 35 0. 4 0. 45 0. 5 0. 55 (RWF 2,000) (RWF 4,000) (RWF 6,000) (RWF 8,000) ( RWF 10,000) Discount / Inte re st Rate (%) Note: This is a hypothetical project. PITT Management Resources Page 28 of 176 Investment Appraisal Training Manual for Public Projects Using excel financial functions to calculate NPV and IRR Microsoft excel has in-built functions that can be used to calculate the two measures. The NPV function calculates the net present value of an investment i. e. using a series of cash flows – annual net cash flows) subjected to a discount rate. The analyst must ensure that the investment costs are negative. The syntax for this function is; = NPV(discount rate, CF0:CFn). While the syntax function for IRR is; =IRR(CF0:CFn). Note, prompt excel by typing the equal (=) sign in the cell before typing the measure (NPV or IRR) and the opening bracket, excel automatically recognizes the action and guides the user. 3. 4. 4 Benefit-to-cost ratios A number of benefit-cost ratio concepts have been developed in the academic world.
For simplicity, let us consider only two concepts, referred to as the gross and net B/C ratio and defined respectively as: • • Gross B/C ratio = PV of benefits/(PV of capital costs + PV of operating costs). Net B/C ratio = (PV of benefits – PV of operating costs)/PV of capital costs. Continuing with our hypothetical project, the present value of the capital outlay is RWF 25,000, since outlays are often made immediately and as a single amount. The present values of project benefits and operating costs are: • • PV of benefits = RWF 15,000/1. 08 + 15,000/1. 082 + 15,000/1. 83 = RWF 38,656. 45 PV of operating costs = RWF 2,000 + 4,000/1. 08 + 4,000/1. 082 + 2,000/1. 083 = RWF 9,418. 38 Hence the benefit-to-cost ratios are: • • Gross B/C ratio = 38,656. 45/(25,000 + 9418. 38) = 1. 12 Net B/C ratio = (38,656. 45 – 9418. 38)/ 25,000 = 1. 45 In economic terms, a project is judged to be worthwhile if its B/C ratio is greater than 1, which means that the present value of its benefits exceeds the present value of the corresponding costs (either way, in gross or net terms). If one of the above ratios is greater than 1, then the other will be greater than 1 also.
In this case, both ratios are greater than 1, implying that the PITT Management Resources Page 29 of 176 Investment Appraisal Training Manual for Public Projects project is worthwhile on economic grounds. It is not clear however, which of the ratios is the most useful on logical grounds. 3. 4. 5 The payback period The payback period (PP) is the number of years it would take the proj

Don't use plagiarized sources. Get Your Custom Essay on
Appraisal Techniques of Public Investments and Projects
Just from $13/Page
Order Essay
Calculator

Calculate the price of your paper

Total price:$26
Our features

We've got everything to become your favourite writing service

Need a better grade?
We've got you covered.

Order your paper

STAY HOME, SAVE LIVES. Order your paper today and save 15% with the discount code FLIX