Project analysis

Agricultural or natural resource developments might best be defined, explained, analyzed, and understood as “projects.” Projected cash flows over a period of time are required for comparisons among alternative development projects or other investment decisions.

In defining a project, Gittinger (1982) said:

FIGURE 3-1 Pastoral Economies.

We generally think of an agricultural project as an investment activity in which financial resources are expended to create capital assets that produce benefits over an extended period of time. In some projects, however, costs are incurred for production expenses or maintenance from which benefits can normally be expected quickly, usually within about a year.

Range or marginal land development projects (such as seeding) can be viewed in the same terms as an agricultural project, although the investments, costs, and returns may be substantially different in substance and in timing of flows. For example, the returns on a rehabilitation project may take several years to realize depending on the starting conditions and project management. These returns, however, may be in the form of higher stocking rates, which may have caused the problem in the first place.

An alternative approach is to examine potential losses that are avoided through rehabilitation. This approach is similar to determining the benefits of flood control projects. If degradation is not halted, then adjacent agricultural land may be placed at risk.

Gittinger also distinguishes between a project that may be relatively small, or perhaps quite large, but is of a nature that it can be analyzed, evaluated, developed, and administered as a unit. A "program" would typically be larger than a single project, and encompass multiple projects or aspects of development that are beyond the project definition and boundaries.

A project should contain relatively homogeneous resources so that investment requirements, costs, and returns from different parts within the project can be accurately represented. If a project becomes large enough to become heterogeneous, then a part of the project - which may in fact be uneconomical or unfeasible - may be hidden or masked and carried by other parts of the project that are worthy of development. When dealing with scarce resources, the concept of homogeneity within a project is important. Past experience has shown that in many instances projects have failed because of lack of social homogeneity; that is, within the target group of pastoralists, subgroups with contrary interests existed (see, for example, Sanford, 1983).

Economic and Financial Analyses

By definition, the economic analysis compares all returns and costs associated with a project during its useful life. Costs include initial and recurring annual expenditures, whereas the revenues include returns as a result of the project over and above what they would have been without it.

Financial or cash flow analysis is the determination of the project's cash flow positions over the period of the project. This shows whether the project is self-supporting or whether deficits are likely to develop. It is simply to compare revenues and expenditures, including debt service on an annual cash basis. The objective of financial analysis is to consider and make estimates of the effects the flow of project costs and returns will have on people participating directly in the project, including families or community groups that make direct use of the project and the primary users. Financial analyses also must consider administration, management, and taxes of the project and costs to the government and donors for those activities.

In financial analyses, market prices, if available, are used to reflect the value of production. Project returns may also include a very significant contribution in the form of food or fuel consumed directly in the household. If subsidies are paid by the government in association with the development of a project, then that also becomes part of the income to the direct beneficiaries from the standpoint of financial analysis. Financial analysis also considers revenue to the goveronment (taxes) for project administration, which have been considered in the costs of the primary beneficiaries (users).

The "economic" aspects of project analyses and evaluation, in contrast to financial aspects, considers the project from the standpoint of the affected society and economy as a whole. Financial and economic analyses differ in three significant ways:

1. Taxes that are treated as costs to primary project participants in financial analyses are viewed by government and society as revenues, not costs.
2. In economic analysis, market prices may be adjusted and become "shadow" or "accounting" prices or “social costs/benefits" to reflect more accurately the economic values to society.
3. In economic analysis, interest on capital and repayment of borrowed capital are not treated as project costs. Although interest is a cost to the project, it is a return to society and the economy as a whole, if actually earned, and hence becomes a "wash" item in economic analysis and accounting for the project. Similarly, the repayment of borrowed capital, although a requirement for the project, neither increases nor decreases net national product.

Comparison Without and With a Project

The purpose of project analysis is to identify and estimate benefits and costs that will arise "without" the project and compare them with benefits and costs "with" the proposed project. The difference between them is the incremental or marginal net benefit arising from the project.

The results of the without-with comparisons may be the same as comparing a particular project situation "before" and "after." Often, however, the comparisons are not the same and may be greatly different because productivity may improve (increase) even without a project. Hence, the projection of the without situation would reflect higher productivity and returns than the current or before project situation. The benefits from a project designed to improve productivity at a more rapid rate than would occur without the project would be overstated by a before and after comparison, because improvements without the project are ignored.

Conversely, a different, perhaps more common, and certainly more serious situation could be one of rapid deterioration in productivity and resource or environmental conditions without a project. A project could be designed with the aim of ameliorating or reversing the deterioration; improved productivity could be a distinct bonus. It may therefore be difficult to compare or economically justify such a project when it may only retard the rate of degradation and keep the returns constant. Intangible benefits must then be considered such as the quality of the environment and the costs associated with people moving to urban centers to escape declining land productivity.

Decision Making

A decision needs to be taken that leads to implementation, modification, or cancellation of the project. Certain costs and benefits (payoffs) are associated with any of these decisions. The decision may be to endorse the project and proceed with implementation based on a degree of uncertainty.

Problems and sources of uncertainty are classified in five categories:

1. Price structures and changes (values)
2. Production methods and responses, including weather effects and other natural phenomena (technical input/output coefficients)
3. Prospective technological developments
4. The behavior and capacities of people associated with the project
5. The economic, political, and social contexts in which a range improvement project exists.

All these sources of uncertainty affect the analysis of projects and are factors to be reckoned with in implementation and evaluation of results.

The basic principle for carrying out an economic analysis is to compare alternatives on an equivalent basis, such as a fixed output, time frame, and constant dollar values. In the analysis, the quantifiable assumptions must first be established as follows:

· All baseline project assumptions, such as the period of analysis, discount rate, cost of capital, and other economic and financial variables must be determined.
· Estimates must be made of project costs including capital costs, onetime costs such as permits, annual operating and maintenance costs, and provisions for renewals and replacements. Estimates of fees, construction, labor and materials, and legal fees must all be determined and placed within the desired schedule.
· Project benefits, principally the increased production, must be ascertained.
· The source of financing and the specific terms of the loan must be defined.
· An appropriate economic analysis methodology must be chosen, and economic and financial feasibility must be established.
· A sensitivity analysis must be performed to determine how costs and benefits react to variations in such factors as discount rate, financing, and productivity.
· The persons or groups of persons who gain and who lose by the introduction of the project must be identified; there are always some losers.

The common approach to economic analyses has been to compare costs and revenues over a consistent time period on a ratio basis or net positive benefit basis. Several measures using discounted cash flow techniques can be employed: internal rate of return, benefit-cost ratio, net present value, and life-cycle costs. Each technique has its advantages, disadvantages, and appropriate applications.

Discount Rate

The discount rate is used for determining economic feasibility, whereas the interest rate is used to ascertain financial feasibility. The proper rate to use for testing economic feasibility is the opportunity cost of capital to society. This is the rate of return that could be earned by investing the capital cost of the project in a venture of similar risk or an alternative marginal project.

Discounted Cash Flow

One of the basic tools for determining economic feasibility is discounted cash flow. All cash expenditures are tabulated for comparison during the chosen period each year. The total cash expenditure for each year is then discounted to the present and cumulatively added to a single sum. This sum is then compared with similar sums of discounted expenditures for alternatives. The alternative with the smallest sum is clearly the least costly. A similar comparison is made with cash revenues or receipts for the same period. The ratio between the sum of the discounted receipts and the sum of the discounted expenditures yields the benefit-cost ratio.

Certain rules must be followed in making discounted cash flow analyses:

· The same period of years must be used for each alternative set of cash expenditures and each alternative set of cash receipts.
· The alternatives must have the same production and capacity. In some cases, this may require adjustments to the costs of the lowest cost alternative.
· Cash expenditures will include renewals and replacements; however, if the years in which these will be made cannot be accurately predicted, an estimated average annual cash expenditure for renewals and replacements as well as an accelerated depreciation schedule can be used, since those costs will occur far in the future.

Discounting transforms all future costs and revenues into the present time frame so they can be compared on a current monetary basis. These sums are simply called the present worth or present value. All future expenditures and revenues are modified or discounted by a factor that provides escalation arising from opportunity costs and resource depletion.

The benefit-cost ratio technique is perhaps the most commonly applied in analyzing capital projects. The method compares the current worth of costs and benefits on a ratio basis. Projects with a ratio of less than one are generally discarded.