0 Lecture Notes ECON 437/837: ECONOMIC COST- BENEFIT ANALYSIS Lecture Nine 1 STAKEHOLDER IMPACTS IMPACTS OF PROJECTS 2 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. 3 For Each Input and Output Variable: Economic = Financial + 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 + PV Stakeholder Impacts Note: Stakeholder Impacts are often called externalities of project 4 General Relationship NPV ECO eco = NPV FIN eco + PV EXT eco 5 1.Identify the externalities. 2.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. Stakeholder Analysis is composed of six distinct steps 6 Stakeholder Analysis is composed of six distinct steps (contd) 4.Allocate the externalities across the various stakeholders of the project. 5.Summarize the distribution of the projects externalities and net benefits according to the key stakeholders in society. 6. Reconcile the economic and financial resource flow statements with the distributional impacts. 7 Financial, Economic and Distributive Effects of Project to Supply Non-Tradable Goods with No Distortions Financial Value of Output = Q s CBQ d or P 1 (Q d -Q s ) Economic Value of Output = Q s CABQ d Difference (Economic - Financial) = CAB CAB = P 1 P 0 AB -P 1 P 0 AC = Gain in Consumer Surplus - Loss in Producer Surplus Economic Value = Financial Value + Gain in Consumer Surplus - Loss in Producer Surplus = Financial Value + Distributive Impacts QdQd Q0Q0 QsQs S Q C A B S + Project P1P1 P0P0 P D E 8 Financial, Economic and Distributive Effects of Project to Supply Non-Tradable Goods with Unit Tax CAB = P S 1 P S 0 AB P S 1 P S 0 AC Since P S 1 P S 0 AB = P d 1 P d 0 EF Therefore, CAB = P d 1 P d 0 EF P S 1 P S 0 AC = 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 Q QdQd S Q0Q0 C B S + Project QSQS P P d1d1 P(P 0 +T) = d0d0 P s1s1 s0s0 P E F A D1D1 D0D0 Financial Value of Output = Q s CBQ d Economic Value of Output = Q s CAQ 0 + Q 0 ABQ d +AEFB Increase in Government Revenue = AEFB 9 Measuring Distributive Impact from Financial and Economic Values of Inputs with Tariffs Financial Cost of Importable Goods = Q d 1 CFQ d 2 Economic Cost of Importable Goods = Q d 1 GHQ d 2 *[1+(E e /E m - 1)] where (E e /E m - 1) = Foreign Exchange Premium (FEP) Financial Cost - Economic Cost = GCFH Q d 1 GHQ d 2 *(E e /E m - 1) = Gain in Tariff Revenues to Government Loss in Government Revenues due to foreign exchange premium on additional use of foreign exchange Q A H D + Project P CIF =P w Q P P CIF (1+t)=P W (1+t) D G CB F d2d2 S s0s0 Q s1s1 d1d1 d0d0 Q Q E Q 10 Examples Who benefits from worker transportation? Why was the Makar Port built? 11 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. Workers Transportation Case 12 Workers Transportation Case (contd) 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 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%. 13 Workers Transportation Case (contd) Table 1: Financial Appraisal Cash Inflows Receipts $16,679 4,000 0 Final in use values$6, ,000 Total Inflows 4,000 10,000 Cash Outflows Capital Expenditures Bus purchase20,000 Tariff on Bus5,000 Operating Expenses Labor10,425 2,500 0 Fuel2, Spare parts Total Outflows 37,927 28,1003,100 0 Net Cash Flow -15, , ,000 NPV Financial at 6%-13,509 NPV Financial at 10%-15,038 14 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 = # of workers $/day Demand for workers transportation Net Benefit to workers Net Benefit to workers 15 Workers Transportation Case (contd) 16 Table 3: Distribution of Net Benefits of the Externalities to Stakeholders Workers Transportation Case (contd) Reconciliation of Financial, Economic, and Distributive Analysis NPV Financial+SUM of PV of externalities at economic discount rate 10, ,03825,525 NPV Economic = PV GovernmentWorkersDriver Receipts18,764 Final in use values(1,242) -1,242 TOTAL INFLOWS CASH OUTFLOWS Capital Expenditures Bus purchase0 Tariff on Bus(5,000)5,000 Operating Expenses Driver(2,085) 2,085 Fuel(834) 834 Spare parts(83) 83 Total Externalities/Distribution 25,5254,67618,7642,085 17 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. 18 Project Outcome (with Project) Deterministic case appeared good with partial financial analysis: - NPV Financial (with Project) = million pesos Analysis shows project provide a negative economic performance ( million pesos) Project was implemented Port Rehabilitation and Expansion: The Makar Port Project (contd) 19 Port Rehabilitation and Expansion: The Makar Port Project (Contd) Incremental Financial-Economic Analysis Note: Exchange rate in the Philippines in Year 1 is 27 pesos/US dollar (1994). NPV (Total Investment Point of View) NPV (Economic Point of View) With Project (000s of Pesos) 10,760 (105,576) Without Project (000s of Pesos) 19,453 25,683 Incremental (000s of Pesos) (8,693) (131,259) NPV (Total Investment Point of View) NPV (Economic Point of View) With Project (000s of Pesos) 10,760 (105,576) Without Project (000s of Pesos) 19,453 25,683 Incremental (000s of Pesos) (8,693) (131,259) 20 Financial Analysis -- Incremental Financial Cash Flow Statement (Real) -- ( thousands Peso ) 21 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. 22 Economic Analysis -- Incremental Economic Net Benefit Flow Statement -- (thousands Peso) Year 1Year 2Year 3Year 4Year 5Year 6Year 10Year 15Year 16 RECEIPTS: Port revenues - local----1,3592,2766,8958, foreign Total Port Revenues----1,6082,5567,3838,639- Benefit to ship owners due to reduction in ships' waiting time---25,48431,26433,53935,44436,491- Benefit to shippers due to reduction in animal weight loss----13,33113,90616,20419,715- Rental income from - Container Yard I-3, Container Yard II-0001,0002,0006,0009,000- Other Income69 - USAID Grant and Gov. Contribution Liquidation Values: ,916 Total Cash Receipts693,069 28,55350,27255,07068,10076,914316,916 EXPENDITURES: Investment cost - non tradable21,81896,550141,82245, tradable2,59687,515130,37354, Operating Cost:----9,044 - Loss of rental income from term. shed1,100 - Change in Cash balance (397) Change in Accounts Receivable (793) Change in Accounts Payable----(1,329)(121) 1,208 Total Expenditures25,514185,165273,295100,581 9,05610,19010,21910,08219 NET CASH FLOW(25,445)(182,096)(270,226)(72,028)41,21644,88057,88166,832316,898 NET PRESENT VALUE (at 10.3%) (131,259) INTERNAL RATE OF RETURN5.88% 23 Stakeholder Analysis (thousands Peso) 24 Stakeholder Analysis Key Question: Why was this BAD project implemented? The Philippines wasted million pesos in order to transfer income to a few ship- owners/shippers. 25 BASIC NEEDS ANALYSIS 26 Basic Needs Appraisal 1.Financial analysis considers the views of all those who have a financial interest in the project owners, buyers, sellers. 2.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. 3.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. 4.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. 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 27 28 Basic Needs Externality Approach This is a practical approach for evaluating community wide externalities arising from the increased level of basic needs achievement 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. 29 Figure 1: Basic Needs Externalities Associated With Each Decile of Poor Typical Private Demand Curve of the 4th Decile Typical Private Demand Curve of the 1st Decile Typical Private Demand Curve of the 2nd Decile Typical Private Demand Curve of the 3rd Decile Basic Needs Externality Price Quantity per Family PMPM BNE 1 BNE 2 BNE 3 X Y0Y0 Y 0 X is associated with a society that generates high basic needs externalities. Y 1 X is associated with a society that generates low basic needs externalities. Y1Y1 30 Figure 2: Basic Need Externality Caused by Project Lowering Cost of Service (Example: Potable Water Project Lowers Coping Cost) Price P0MP0M Typical Private Demand Curve of the 1st Decile Basic Needs Externality Typical Private Demand Curve of the 4th Decile Clean Water Consumption (Quantity per Family) Q0Q0 Q1Q1 M N T S R Type A Externality = MNST P1MP1M Note: Quality of family health = f (quantity of clean water consumed) 31 Figure 3: Basic Needs Externality Caused by Increased Demand due to the Income Effect of an Investment Project D1D1 D1D1 Typical Private Demand Curve of the 1st Decile (After the Income Change) Typical Private Demand Curve of the 1st Decile Typical Private Demand Curve of the 4th Decile Basic Needs Externality PMPM M T N S Type B Externality = MNST Quantity per FamilyQ0Q0 Q1Q1 X Y 32 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. 33 Olifants-Sand Water Transfer Schem e 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. 34 Present Value of Basic Needs Externality from Increased Consumption of Water by Poor* due to Lower Prices Types of Consumer PV of volume of increased water consumption (million cubic meters) b PV of Externality (Millions of Rand) Olifants Rural Centers a Lebalelo Rural Total (Poor communities with water shortages) (20.77% of Total Demand) 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. a Proportion 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 M 3. Value of basic needs externality of target consumption for Olifants Rural can be estimated as R1.9*52.66*0.80 m. b The 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). 35 Stakeholder Impacts on Earnings of the Olifants-Sand Water Transfer Scheme in the Northern Province of South Africa Stakeholder Present Value of Impact (millions of Rand) Lebowakgomo Area 74.0 Rural Users Mining Polokwane 26.6 Irrigation 77.0 Labor 13.2 36 Basic Needs Externality from Improved Housing, Nutrition, Health, Education of Poor* from Increased Real Income Stakeholder Value of Impact (millions of Rand) (1) Basic needs externality 30% premium (2) Rural Areas Users a Labor b Total Note: *The poor are defined as those in the bottom 40 percent of the income distribution. a Poor 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. b Poor 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. 37 Importance of Basic Needs Externalities Present Value (Millions of Rand) PV basic needs externality due to price effect PV basic needs externality due to income effect78.59 Total basic needs externality PV total cost of project714.1 Ratio of basic needs externality to total investment costs25.55% 38 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. ECONOMIC ASPECTS OF FOREIGN FINANCI NG 40 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. 41 Marginal Economic Cost Of Foreign Financing S if MC C ii f Q 0 Q 1 D 0 f D 0 f + B B A % %MEC 0 i 0 f E D %MEC Quantity of Foreign Borrowing Negative externality from foreign financing = ABCD 42 MC : Marginal economic cost of funds r f : real cost of foreign financing t w : 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] f s : the supply elasticity of foreign funds to a country with respect to the cost of funds the country pays for its foreign financing 43 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: NPV e = B g + B p + B f C g C p C f If the project financed from foreign sources is entirely incremental, the net benefits of the project accrued to the host country will be: NPV e host = NPV e + (1+ )(C f B f ) where stands for the foreign exchange premium. 44 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 (B f t ), 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 (B af t ), t=0.n. Thus, the net cost to the host country will be measure by B f t - B af t. 45 Non-Incremental Foreign Investment (contd) We can estimate parameter Z, which is the the ratio of the present value (discounted at r f %) 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. r f refers to the normal rate of return to the total foreign capital in the host country. 46 Non-Incremental Foreign Investment (contd) PV (foreign equity + foreign debt) at r f discount rate PV (foreign dividend + foreign interest + foreign repayment) for project at r f discount rate Z = If Z = 1, the foreign investment owners will receive a normal return (r f ). If Z > 1, then foreigners would be earning less than a r f % return by investing in the project. If Z < 1, then foreigners would be earning more than a r f % real return. 47 Non-Incremental Foreign Investment (contd) 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. B af t = (Z)(B f t ), t=0n. Thus, the stream of additional economic costs created by foreign financing is E f t = (B f t B af t ), t=0,1,.. The total adjustment is to subtract (1+ )PV(E f ) using the economic opportunity cost of capital as the discount rate. NPV e host = NPV e (1 + )PV(E f ) Financial NPV of Utility to Percentage Change in Tariff Structure: A case in Panama Tariff (000 Balboas) -40%-2, %27, %37, %46, %54,508 -5%62,556 0%70,210 5%77,470 10%84,336 Z =.1242, PV(E f = -142,109 48 49 Sensitivity of Economic NPV to Change in Water Tariffs If accounting for foreign financing, then the Economic NPV: 10,406 142,109 = - 131,703 NPV 9.3% = 10,406 Change in Water Tariffs (percent) Economic NPV (B thousands) -15%53, %45,766 -5%37,495 0%28,845 5%19,815 10%10,406 15%618 20%-9,549 50 Stakeholder Analysis without taking account of foreign financing PV economic flow = PV fin. flow + PV econ. d.r. 10, , ,772 P e = P f + E i NPV e e = NPV f e + PV e (EXT i ) 51 Project Net Benefits without Accounting for Foreign Financing (thousand Balboas) Government Metered Customers (also w/o project) Metered Customers (unmetered with 24-hour supply w/o project) Commercial & Industrial Customers -24,260 Metered Customers (unmetered with intermittent water and cope with tanks w/o project) Non- revenue consumers w/o project Metered Customers (unmetered with intermittent water and dont cope with tanks w/o project) Unmetered Customers W/ o project 5, ,25827,678 -2,244 SUM EXT. = -129, , ,227-9,486 NPV Externalities 9.3% NPV Externalities 9.3% 52 Stakeholder Analysis with Taking Account of Foreign Financing PV economic flow = PV fin. flow + PV econ. d.r. -131, , ,881 P e = P f + E i NPV e e = NPV f e + PV e (EXT i ) 53 Project Net benefits with Accounting for Foreign Financing (thousand Balboas) Government Metered Customers (also w/o project) Metered Customers (unmetered with 24-hour supply w/o project) Commercial & Industrial Customers -24,260 Metered Customers (unmetered with intermittent water and cope with tanks w/o project) Non- revenue consumers w/o project Metered Customers (unmetered with intermittent water and dont cope with tanks w/o project) Unmetered Customers W/ o project 5, ,25827,678 -2,244 SUM EXT. = -271, , ,227-9,486 NPV Externalities 9.3% NPV Externalities 9.3% Loss to Economy from foreign financing -142,109 54 Concluding Remarks In the vast majority of cases, a project that is being financed from foreign sources will be simply reallocating the total amount of foreign investment available to the country. Public-Private partnerships that are carried out either through non-arms-length arrangements or by suboptimal risk management will generate either large wealth transfers or payments to foreign entities. 55 Concluding Remarks (contd) Such transfers to foreigners are always an economic cost, but if a necessary compensation for special risks associated with the foreign financing they are an economic cost to host country. Guarantees that are provided by the government to domestic investors may alter behavior and help or hurt a project. Triggering of the guarantee is essentially a transfer from the government to the domestic or foreign financial institutions. In case of foreign investment it is guaranteeing the value of the economic cost of the investment.