Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Nine

1. Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Nine

2. STAKEHOLDER IMPACTS OF PROJECTS

3. Assess Stakeholder Impacts of Projects • A comparison between economic and financial values tells us who wins and who loses from a specific project, i.e., the Stakeholders.

4. For Each Input and Output Variable: • Economic = Financial + S Stakeholder Impacts • Example of a non-traded good with a sales tax: • Economic Value = Financial Value + Change in Government Tax Revenues + Increase in Consumer Benefits – Loss in Profits to other producers • Taken over all variables and time periods of project (using a common discount rate) - NPV economic = NPV financial + S PV Stakeholder Impacts Note: Stakeholder Impacts are often called externalities of project

5. General Relationship NPVECOeco = NPVFINeco + PVEXTeco

6. Stakeholder Analysis is composed of six distinct steps • Identify the externalities. • Measure the net impact of the externalities in each market as the real economic values of resource flows less the real financial values of resource flows. 3. Measure the values of the various externalities throughout the life of the project and calculate their present values by using the economic discount rate.

7. Stakeholder Analysis is composed of six distinct steps (cont’d) • Allocate the externalities across the various stakeholders of the project. • Summarize the distribution of the project’s externalities and net benefits according to the key stakeholders in society. 6. Reconcile the economic and financial resource flow statements with the distributional impacts.

8. P S S + Project A P0 B P1 C E D Q Qs Q0 Qd Financial, Economic and Distributive Effects of Project to Supply Non-Tradable Goods with No Distortions Financial Value of Output = QsCBQd or P1 (Qd -Qs) Economic Value of Output = QsCABQd Difference (Economic - Financial) = CAB CAB = P1P0AB -P1P0AC = Gain in Consumer Surplus - Loss in Producer Surplus Economic Value = Financial Value + Gain in Consumer Surplus - Loss in Producer Surplus = Financial Value + Distributive Impacts

9. P S d0 E (P0+T) = P S + Project P d1 Financial Value of Output = QsCBQd Economic Value of Output = QsCAQ0+ Q0ABQd +AEFB Increase in Government Revenue = AEFB F A s0 P s1 P C B D0 D1 Q QS Q0 Qd CAB = PS1PS0AB – PS1PS0AC Since PS1PS0AB = Pd1Pd0EF Therefore, CAB = Pd1Pd0EF – PS1PS0AC = Gain in Consumer Surplus - Loss in Producer Surplus Economic Value of Output = Financial Value of Output + Change in Gov. Tax Revenues + Increases in Consumer Surplus - Loss in Producer Surplus Financial, Economic and Distributive Effects of Project to Supply Non-Tradable Goods with Unit Tax

10. P S B C F PCIF(1+t)=PW(1+t) A E PCIF=Pw H G D + Project D Q Q s0 Q s1 Q d1 Q d0 Q d2 Measuring Distributive Impact from Financial and Economic Values of Inputs with Tariffs Financial Cost of Importable Goods = Qd1CFQd2 Economic Cost of Importable Goods = Qd1GHQd2*[1+(Ee/Em - 1)] where (Ee/Em - 1) = Foreign Exchange Premium (FEP) Financial Cost - Economic Cost = GCFH – Qd1GHQd2*(Ee/Em - 1) = Gain in Tariff Revenues to Government – Loss in Government Revenues due to foreign exchange premium onadditional use of foreign exchange

11. Examples • Who benefits from worker transportation? • Why was the Makar Port built?

12. Workers Transportation Case Basic Facts • Factory currently employs 20 workers. These workers take taxis every day at a cost of $1.00. • Factory wants to employ 40 workers, but can not recruit any additional worker without either subsidizing transportation or paying higher wages. • The proposal is to buy a bus for a total of $25,000 including $5,000 of import tariff. The bus is expected to have a value of $10,000 in year 5. • The bus will operate for 250 days per year. • The charge per person/day on the bus will be 40 cents. • A driver will be hired to operate and maintain the bus at a wage of $10.00 per day. • The cost of oil and gas will be $2.00 per day. • The spare parts bill is expected to be $100 per year. • No income taxes are levied on the income of public enterprise.

13. Workers Transportation Case (cont’d) • The economic opportunity cost of employing the driver is equal to approximately 80% of his wage. • The conversion factor for oil and gas is estimated to be 0.60 because of the high taxes imposed on their purchase price. • Spare parts have a tariff and taxes on them that are equal to 25 percent of their CIF price. Thus, the spare parts conversion factor is equal to 0.80. • The ratio of the economic exchange rate to the market exchange rate is equal to 1. • The financial discount rate is equal to 6%, and the economic discount rate is equal to 10%.

14. Table 1: Financial Appraisal PV @10% 0 1 2 3 4 5 Cash Inflows $16,679 Receipts 4,000 4,000 4,000 4,000 4,000 0 Final in use values $6,209 0 0 0 0 0 10,000 4,000 4,000 4,000 4,000 4,000 10,000 Total Inflows Cash Outflows Capital Expenditures Bus purchase 20,000 20,000 Tariff on Bus 5,000 5,000 Operating Expenses Labor 10,425 2,500 2,500 2,500 2,500 2,500 0 Fuel 2,085 500 500 500 500 500 0 Spare parts 417 100 100 100 100 100 0 Outflows Total 28,100 3,100 3,100 3,100 3,100 0 37,927 Net Cash Flow -15,038 -24,100 900 900 900 900 10,000 NPV Financial at 6% -13,509 NPV Financial at 10% -15,038 Workers Transportation Case (cont’d)

15. $/day Demand for workers’ transportation 1.00 Net Benefit to workers Net Benefit to workers 0.40 20 40 # of workers Measurement of Economic Benefits Financial Revenue/person/day = $0.40 Economic Benefits/person/day = [(20*$1.0+20*($1+$0.40)/2]/40 = $0.85 Conversion Factor = 0.85/0.40 = 2.125

16. Table 2: Economic Appraisal Conversion Factor 0 1 2 3 4 5 PV at 10% Cash Inflows Receipts 2.125 35,444 8,500 8,500 8,500 8,500 8,500 0 Final in use values 0.8 4,967 0 0 0 0 0 8000 40,411 8,500 8,500 8,500 8,500 8,500 8,000 TOTAL INFLOWS Cash Outflows Capital Expenditures Bus purchase 1 20000 20000 Tariff on Bus 0 0 0 Operating Expenses Labor 0.8 8,340 2000 2000 2000 2000 2000 0 Fuel 0.6 1,251 300 300 300 300 300 0 Spare parts 0.8 334 80 80 80 80 80 0 29,924 22,380 2,380 2,380 2,380 2,380 - Outflows Total Net Cash Flow 10,487 (13,880) 6,120 6,120 6,120 6,120 8,000 NPV Economic at 10% 10,487 Workers Transportation Case (cont’d)

17. PV Externalities Government Workers Driver @10% Receipts 18,764 18,764 Final in use values (1,242) -1,242 TOTAL INFLOWS CASH OUTFLOWS Capital Expenditures Bus purchase 0 Tariff on Bus (5,000) 5,000 Operating Expenses Driver (2,085) 2,085 Fuel (834) 834 Spare parts (83) 83 25,525 4,676 18,764 2,085 Externalities/Distribution Total Reconciliation of Financial, Economic, and Distributive Analysis NPV Financial + SUM of PV of externalities NPV Economic = at economic discount rate at economic discount rate at economic discount rate 10,487 -15,038 25,525 Workers Transportation Case (cont’d) Table 3: Distribution of Net Benefits of the Externalities to Stakeholders

18. Port Rehabilitation and Expansion: The Makar Port Project in the Philippines Basic Facts: • Makar Port, located in General Santos City at the northern side of Sarangani Bay, a well-protected bay in Mindanao, lies along the main north-south trading axis which skirts Mindanao on its western shore. • The objectives of the project are to increase the capacity and improve the efficiency of cargo handling facilities at the port to accommodate future flows. • The project will cost approximately 635 million pesos (about US$23.5 million). • 75% of the total project cost will be provided as a grant by the US Agency for International Development (USAID) and the other 25% will be provided from counterpart contribution by the Philippine government.

19. Port Rehabilitation and Expansion: The Makar Port Project (cont’d) • Project Outcome (with Project) • Deterministic case appeared good with partial financial analysis: • - NPV Financial (with Project) = 10.76 million pesos • Analysis shows project provide a negative economic performance (-105.58 million pesos) • Project was implemented

20. With Project With Project Without Project Without Project Incremental Incremental (000s of Pesos) (000s of Pesos) (000s of Pesos) (000s of Pesos) (000s of Pesos) (000s of Pesos) NPV (Total Investment Point of View) NPV (Total Investment Point of View) 10,760 10,760 19,453 19,453 (8,693) (8,693) (105,576) (105,576) 25,683 25,683 (131,259) (131,259) NPV (Economic Point of View) NPV (Economic Point of View) Note: Exchange rate in the Philippines in Year 1 is 27 pesos/US dollar (1994). Port Rehabilitation and Expansion: The Makar Port Project (Cont’d) Incremental Financial-Economic Analysis

21. Financial Analysis -- Incremental Financial Cash Flow Statement (Real) -- (thousands Peso) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 10 Year 15 Year 16 RECEIPTS - - - - 1,359 2,276 6,895 8,120 - Port Revenues - local - - - - 216 243 425 452 - - foreign - - - - 1,576 2,519 7,319 8,572 - Total port revenues - 3,000 3,000 3,000 3,000 3,000 3,000 3,000 - Rental income from - Container Yard I - - - - 1,000 2,000 6,000 9,000 - - Container Yard II 69 69 69 69 69 69 69 69 - Other Income 22,148 155,088 219,215 79,719 - - - - - USAID Grant and Gov. Contribution - - - - - - - - 340,810 Liquidation Values: 22,217 158,157 222,284 82,788 5,645 7,588 16,388 20,641 340,810 Total Cash Receipts EXPENDITURES 22,631 103,995 153,285 49,006 - - - - - Investment cost - non tradable 2,758 93,124 139,002 57,285 - - - - - - tradable - - - - 9,017 9,017 9,017 9,017 - Operating Cost: 1,100 1,100 1,100 1,100 1,100 1,100 1,100 1,100 - Loss of rental income - - - - 79 54 64 19 (390) Change in Cash balance - - - - 158 109 128 38 (779) Change in Accounts Receivable - - - - (1,353) (123) (123) (123) 1,230 Change in Accounts Payable 26,489 198,219 293,386 107,392 9,001 10,157 10,186 10,051 61 Total Expenditures (4,272) (40,063) (71,103) (24,604) (3,356) (2,569) 6,202 10,589 340,750 NET CASH FLOW (8,693) NET PRESENT VALUE (at 9%) .

22. Economic Benefits of the Makar Port Project • Additional port revenue from expansion in traffic including foreign exchange premium. • Additional rental income from containers yards. • Reduction in waiting time of ships. • Reduction in animal weight loss from waiting on ship.

23. Economic Analysis -- Incremental Economic Net Benefit Flow Statement -- (thousands Peso) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 10 Year 15 Year 16 RECEIPTS: Port revenues - local - - - - 1,359 2,276 6,895 8,120 - - foreign - - - - 249 280 488 520 - Total Port Revenues - - - - 1,608 2,556 7,383 8,639 - Benefit to ship owners due to reduction in ships' waiting time - - - 25,484 31,264 33,539 35,444 36,491 - Benefit to shippers due to reduction in animal weight loss - - - - 13,331 13,906 16,204 19,715 - Rental income from - Container Yard I - 3,000 3,000 3,000 3,000 3,000 3,000 3,000 - - Container Yard II - 0 0 0 1,000 2,000 6,000 9,000 - Other Income 69 69 69 69 69 69 69 69 - USAID Grant and Gov. Contribution - - - - - - - - - Liquidation Values: - - - - - - - - 316,916 Total Cash Receipts 69 3,069 3,069 28,553 50,272 55,070 68,100 76,914 316,916 EXPENDITURES: Investment cost - non tradable 21,818 96,550 141,822 45,422 - - - - - - tradable 2,596 87,515 130,373 54,059 - - - - - Operating Cost: - - - - 9,044 9,044 9,044 9,044 - Loss of rental income from term. shed 1,100 1,100 1,100 1,100 1,100 1,100 1,100 1,100 - Change in Cash balance - - - - 80 55 65 20 (397) Change in Accounts Receivable - - - - 160 111 130 39 (793) Change in Accounts Payable - - - - (1,329) (121) (121) (121) 1,208 Total Expenditures 25,514 185,165 273,295 100,581 9,056 10,190 10,219 10,082 19 NET CASH FLOW (25,445) (182,096) (270,226) (72,028) 41,216 44,880 57,881 66,832 316,898 (131,259) NET PRESENT VALUE (at 10.3%) INTERNAL RATE OF RETURN 5.88%

24. (A) (B) (C) (D) (E) PV Financial at PV Economic at PV of Allocation of Externalities Economic Discount Economic Discount Externalities Shipowners/ Stakeholder Analysis ITEM Rate of 10.3% Rate of 10.3% (B - A) Government Shippers (thousands Peso) RECEIPTS: 25,677 25,928 250 250 - Total Port Revenues Benefit to ship owners/shippers due to - 187,684 187,684 - 187,684 reduction in ships' waiting time Benefit to livestock shippers due to - 77,025 77,025 - 77,025 reduction in animal wt. loss 22,100 22,100 - - - Rental income from - Container Yard I 23,895 23,895 - - - - Container Yard II 577 577 - - - Other Income 404,200 - (404,200) (404,200) - USAID Grant 81,587 75,867 (5,720) (5,720) - Liquidation Values: 558,037 413,076 (144,961) (409,670) 264,709 Total Cash Receipts EXPENDITURES: 280,673 260,925 (19,749) (19,749) - Investment cost - nontradable 245,332 230,517 (14,815) (14,815) - - tradable 44,000 44,135 135 135 - Operating Cost: 9,203 9,203 - - - Loss of rental income from term. shed 223 227 4 4 - Change in Cash balance 446 454 8 8 - Change in Accounts Receivable (1,145) (1,126) 20 20 - Change in Accounts Payable 578,732 544,335 (34,397) (34,397) - Total Expenditures (20,695) (131,259) (110,564) (375,272) 264,709 NET CASH FLOW

25. Stakeholder Analysis • Key Question: • Why was this BAD project implemented? • The Philippines wasted 131.3 million pesos in order to transfer income to a few ship-owners/shippers.

26. BASIC NEEDS ANALYSIS

27. Basic Needs Appraisal • Financial analysis considers the views of all those who have a financial interest in the project – owners, buyers, sellers. • Normally the economic appraisal evaluates additional consumption by the demanders’ willingness to pay, and any displacement of other suppliers by the economic value of resources saved by these suppliers. • The attainment of the basic needs of poorer members of the community may also generate an increase in the total satisfaction of other better off members of the community. • This public good externality needs to be included in the benefits of investments that lead to satisfying of the basic needs by disadvantaged members of the community.

28. Hierarchy of Minimum Basic Needs • Survival Needs: food and nutrition, health, water and sanitation, and clothing • Security Needs: shelter, peace, income, employment • Enabling Needs: basic education and literacy, family care and psychosocial needs

29. Basic Needs Externality Approach • This is a practical approach for evaluating community wide externalities arising from the increased level of basic needsachievement by the less fortunate members of society. • Basic needs externality (BNE) approach was introduced by Harberger (1984) to measure this social dimension of a project. • The rationale for BNE approach is not just that the poor should have more income, but that they should have better nutrition, medical care, housing, education, etc.

30. Price Typical Private Demand Curve of the 4th Decile Y0 Basic Needs Externality BNE1 BNE2 Y1 BNE3 PM X Typical Private Demand Curve of the 1st Decile Typical Private Demand Curve of the 2nd Decile Typical Private Demand Curve of the 3rd Decile Quantity per Family Y0X is associated with a society that generates high basic needs externalities. Y1X is associated with a society that generates low basic needs externalities. Figure 1: Basic Needs Externalities Associated With Each Decile of Poor

31. Price Basic Needs Externality Typical Private Demand Curve of the 4th Decile M T Type A Externality = MNST P0M S N R P1M Typical Private Demand Curve of the 1st Decile Q0 Q1 Clean Water Consumption (Quantity per Family) Note: Quality of family health = f (quantity of clean water consumed) Figure 2: Basic Need Externality Caused by Project Lowering Cost of Service(Example: Potable Water Project Lowers Coping Cost)

32. Y Typical Private Demand Curve of the 4th Decile Basic Needs Externality M T Type B Externality = MNST S X PM N Typical Private Demand Curve of the 1st Decile (After the Income Change) Typical Private Demand Curve of the 1st Decile D1’ D1 Q0 Q1 Quantity per Family Figure 3: Basic Needs Externality Caused by Increased Demand due to the Income Effect of an Investment Project

33. An Application of Basic Needs Externality Estimation: • Olifants-Sand Water Transfer Scheme • Basic Facts: • The project considered here is “Olifants-Sand Water Transfer Scheme”, which can be best described as a regional bulk water supply system. • It includes a raising of the existing Flag Boshielo (Arabie) dam by 5 meters, construction of the Rooipoort dam and the construction of the Water Transfer Scheme from Rooipoort to Polokwane via Lebowakgomo. • The region affected is the Sekhukhune Cross Border District of Limpopo Province. • This region has an unemployment rate of approximately 68%, compared to the average of 46% in Limpopo Province. • Only about 40% of the households have access to the minimum water supply for drinking, cooking and critical hygiene of 25 liters per capita a day (l/c/d), which is set by the Reconstruction and Development Program of the National Government of South Africa.

34. Olifants-Sand Water Transfer Scheme • The economic analysis indicates that the project has a highly positive NPV. • In the analysis of the basic needs externality, focus is on the improved availability of water and the incomes of the poorest households affected by the project, namely the rural communities. • We assume that the health impact of consuming more clean water is primary due to its use for drinking, cooking and critical hygiene. • The increased availability of potable water is accompanied by a dramatic fall in the costs of water for reasons that has an impact on health, thereby causing the total amount of consumption for these purposes to increase. • With the present very low volumes of water consumption, it is estimated that approximately 80 percent of the incremental potable water provided to poor households by the project would be used for drinking, cooking and critical hygiene.

35. Present Value of Basic Needs Externality from Increased Consumption of Water by Poor* due to Lower Prices Note: *The poor are defined as those in the bottom 40 percent of the income distribution. The two rural communities included in this analysis fall well below this threshold. aProportion of total increment water used for drinking, cooking and critical hygiene = 80%. The economic cost of supply is estimated to be equal to R1.9 per M3. Value of basic needs externality of target consumption for Olifants Rural can be estimated as R1.9*52.66*0.80 m. bThe water volumes are taken from the demand analysis of Cambridge Resources International, Evaluation of the Olifants-Sand WaterTransfer Scheme in the Limpopo Province of South Africa, Cambridge, MA, (2004).

36. Stakeholder Impacts on Earnings of the Olifants-Sand Water Transfer Scheme in the Northern Province of South Africa

37. Basic Needs Externality from Improved Housing, Nutrition, Health, Education of Poor* from Increased Real Income Note: *The poor are defined as those in the bottom 40 percent of the income distribution. aPoor receive 100% of income change; proportion of income spent on basic needs = 75%; basic needs externality = 30% of value of additional private expenditures on basic needs. bPoor receive 80% (suppose 80% are the unskilled labor) of income change; proportion of income spent on basic needs = 75%; basic needs externality = 30% of value of additional private expenditures on basic needs.

38. Importance of Basic Needs Externalities

39. Magnitude of Government Assistance • NPV of the net economic benefits of a private sector project is positive. • NPV of the net financial cash flow is negative. However, the government may want to assist the project since its positive economic NPV will increase the well-being of all people in society. • The government should offer the project the smaller amount required for the project to be undertaken or the value of the positive net economic externalities generated by the project.

40. ECONOMIC ASPECTS OF FOREIGN FINANCING

41. Questions to be addressed At the project level, how do we account for the economic cost of foreign financing? A. Case where all financing is incremental. B. Case where all financing is non-incremental.

42. % C MC %MEC’ B D %MEC E S 0 if i’ f i 0 0 D + B A f f 0 Quantity of Foreign Borrowing D f Q Q 0 1 Marginal Economic Cost Of Foreign Financing Negative externality from foreign financing = ABCD

43. MC : Marginal economic cost of funds rf : real cost of foreign financing tw : effective withholding tax rate  : ratio of [total foreign debt whose interest rate is responsive to changes in the current amount of foreign borrowing] to [total stock of foreign financing] fs: the supply elasticity of foreign funds to a country with respect to the cost of funds the country pays for its foreign financing

44. Incremental Foreign Investment • In an open economy, the net economic benefits from the project are going to be shared by: • the government (g) • other residents of the country (p) • foreigners (f) • The NPV of an investment project, using the economic cost of funds, can be expressed as: NPVe = Bg+ Bp + Bf – Cg – Cp – Cf • If the project financed from foreign sources is entirely incremental, the net benefits of the project accrued to the host country will be: NPVe host= NPVe + (1+)(Cf – Bf) where stands for the foreign exchange premium.

45. Non-Incremental Foreign Investment • When none of the foreign investment is incremental to the host country, the opportunity cost of the investment for the foreigners is the stream of benefits that they would have received from the alternative investment forgone. • Let the stream of dividends, interest and loan repayments, discounted at the EOCK that actually flows from the project to foreigners be (Bft), t=0….n • Let the stream of benefits that foreigner would have been paid by the alternative investments within the host country if this project not undertaken be (Baft), t=0….n. • Thus, the net cost to the host country will be measure by Bft - Baft.

46. Non-Incremental Foreign Investment (cont’d) • We can estimate parameter Z, which is the the ratio of the present value (discounted at rf %) of the stream of foreign equity and debt invested in the project to the present value of the actual stream of the foreign dividends, debt repayment and interest received. • rf refers to the normal rate of return to the total foreign capital in the host country.

47. Non-Incremental Foreign Investment (cont’d) • If Z = 1, the foreign investment owners will receive a normal return (rf). • If Z > 1, then foreigners would be earning less than a rf% return by investing in the project. • If Z < 1, then foreigners would be earning more than a rf% real return. Z = PV (foreign equity + foreign debt) at rf discount rate PV (foreign dividend + foreign interest + foreign repayment) for project at rf discount rate

48. Non-Incremental Foreign Investment (cont’d) • By multiplying this ratio (Z) by the actual stream of dividends, debt repayment, and interest received by foreigners from the project, we can estimate the stream of payments to foreigners that is sufficient to generate a normal rate of return to the foreigners. Baft = (Z)(Bft), t=0…n. Thus, the stream of additional economic costs created by foreign financing is Eft = (Bft – Baft), t=0,1,.. • The total adjustment is to subtract (1+)PV(Ef) using the economic opportunity cost of capital as the discount rate. NPVe host= NPVe – (1 + )PV(Ef)

49. Financial NPV of Utility to Percentage Change in Tariff Structure: A case in Panama Tariff Structure FNPV@15% (000 Balboas) -40% -2,058 -25% 27,999 -20% 37,229 -15% 46,066 -10% 54,508 -5% 62,556 0% 70,210 5% 77,470 10% 84,336 Z =.1242, PV(Ef) @9.3% = -142,109

50. Sensitivity of Economic NPV to Change in Water Tariffs NPV econ @ 9.3% = 10,406 • If accounting for foreign financing, then the Economic NPV: 10,406 – 142,109 = - 131,703