UA&P SBEP 2011-2012 PROJECT ANALYSIS CASES

April 2012 Rolando T. Dy, Ph.D. Executive Director, Center for Food and Agri Business Fellow, FIDEI University of Asia and the Pacific OVERVIEW The divergence between financial profits and social profits are well-known. This is because financial and economic values (revenues and costs) have different valuation. It is good for top executives to have a better understanding of this public policy tool. What is Economic Analysis?
The economic analysis of a project helps select and design projects that contribute to the welfare of a country. Various tools of economic analysis help determine the economic and fiscal impact of the project, including the impact on society and the major stakeholders involved, as well as the projects risks and sustainability. A good economic analysis answers the following questions:

What is the project objective? This helps identify tools for the analysis. A clearly defined objective also helps in identifying the possible alternatives to the project. What will be the impact of the project? This question concerns a counterfactual as the difference between the situation with or without the project is crucial for assessing the incremental costs and benefits of the project. Are there any alternatives to the project? If so how would costs and benefits of the alternatives to achieve the same goal compare to the project in question? Is there economic justification of each separable component of the project? Who gains and who loses if the project is implemented? The analysis has to make sure that the most benefit accrues to the poor. What is the fiscal impact of the project? Is the project financially sustainable and what are the risks involved? Are there any other externalities? What is the environmental impact of the project?

(Adapted from Belli, P. et al (1998) Handbook on Economic Analysis of Investment)

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The following cases are meant to provide analytical depth in the application of project economics. It also serves to integrate learnings from various modules. The cases are: 1. 2. 3. 4. 5. 6. 7. Agriculture Development Project Road Improvement Project Multi-band Project Rice Irrigation Project Sugar Industry Project Cargo Handling Project* Business Education Project*

The priority cases are: Cases 1-5. . The basic skills requirements include: (a) The with project and without project comparison; (b) Internal rate of return - IRR; (c) Net present value -NPV; and (d) Sensitivity analysis of the rate of return.

Caveat: I would appreciate if you can call my attention regarding suggested improvements.

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CASE 1.

AGRI DEVELOPMENT PROJECT

Pacifica is an impoverished province with 80% of the 200,000 inhabitants earning income below the poverty threshold of about Php7,500 per family per month. The major occupations are: coconut, subsistence fishing, and overseas employment. The area is ripe with insurgency due to low income and, in turn, extreme poverty. There are about 20,000 hectares of coconut trees, half of them senile (over 40 years old). The fisher folks also harvest coconut during the lean fishing season of June to October. Both groups are severely under-employed. The educated children have migrated to Manila and Central Luzon, or took up overseas work. The European Union (EU) has approved a poverty reduction program of P300 million. It will fund 80 percent of the project while the provincial government will contribute 20 percent. The EU is optimistic with the project outcomes as the governor, a UA&P-SBEP alumna, could chart a transparent, ethical and accountable government. However, before the EU releases the project, it wants to see viable program components from the financial and economic standpoints. Without hesitation, the governor calls on her SBEP classmates to conduct the economic evaluation and formulate a development strategy. She is confident at the quality of work of her SBEP classmates. Here are the relevant facts: A. Coconut Hybrid Planting With Project (Replanting) The replanting cost totals Php60,000 per hectare (ha), spread over three years: Php30,000 in year (Yr) 1, Php20,000 in Yr 2, and Php10,000 in Yr 3. The projected farm yield (kilograms copra per hectare (ha)): Yr 1-3 - nil; Yr 4 750; Yr 5 - 1,000; Yr 6 - 1,500; Yr 7 - 2,000; Yr 8 - 2,200; Year 20-25, 2,500 Financial Farm Price: Php20 per kg constant prices. Maintenance Cost: Yr 4: Labor Php 7,500; Materials Php5,000 Yr 5-onwards: Php10,000, and Php5,000, respectively. Without Project (Business as Usual) Yield: 500 kilograms (kg)/ha constant over the years. Yr 0-onwards: Labor, P5,000. Economic Price Economic farmgate price is 20% higher than the financial price. Economic price of labor is 60% of the financial price Economic price of materials is 90% of financial price. Questions:
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1. 2. 3. 4.

What is the individual farmer FIRR? What is the overall project FIRR? What is the overall project EIRR? What happens to FIRR and EIRR if (a) Copra price falls by 30%? (b) Replanting cost increases by 30%? 5. How much will price and cost variable change for the FIRR to be 15 percent?

B. Spice Component The EU is concerned that replanting takes time to bear fruits. It suggests that intercropping part of the senile coconut trees would provide front-end dividends. Black pepper was suggested since it is high value and labor-intensive. It can employ surplus labor, particularly, women. Pepper Farm (Per hectare)
Item Yield (kilograms) dried Farm price (Php/kg) Gross Production Value (GPV) (Php) Costs: Materials* Labor Total Cost (Php) Memo items: Labor: person days/ha Unit cost: Php150/day 1 0 100 2 0 Year 3 200 4 800 5 1,200 6-12 1,500

70,000

30,000

20,000

30,000

40,000

50,000

100

50

50

150

200

200

*Fertilizers, etc. as well as land clearing and seedlings in the first year.

Questions: 1. What is the FIRR of the pepper farm? 2. How much will the price and cost variables change for the FIRR to be 15 percent?. 3. Assuming that the forex conversion for GPV is 1.2, materials 1.0; and labor 0.6, what is the expected EIRR? 4. What do you think is the limitation for large expansion of pepper compared to coconut? 5. Would planting vegetables a good option given the distance of Pacific from the market?

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2. RURAL ROAD IMPROVEMENT PACKAGE

Bagong Silangan is a remote community with agriculture and fishing as major sources of incomes. It is 15 kilometers (km) from the main highway. The road is impassable during the rainy months of June to October. The project will rehabilitate some 10 km of access roads from their impassable state during the rainy season into an all-weather road under the project. (a) Construction period: Year 1 at Php 30 M and, Year 2, Php20 M (b) Maintenance: 4% of project cost annually; and rehabilitation every 5 years at 10% of project cost Project Benefits (a) Development Benefits with higher agriculture production; and (b) Savings in vehicle operating costs. The development benefits are calculated from area expansion and increase in farm yield. Below are the main assumptions Development Benefit Streams at economic prices With Project (Per ha) Year 1 Year 2 Year 3 Year 4 Year 5-25 Harvested area (hectare) 100 100 150 250 300 Yield (ton/ha) 2..5 2.6 3.2 3.8 4.5 Production (ton) Farm Price (Php/ton) 25,000 Gross Prod Value (Php) M Less: Prod Cost (Php) M Labor Cost (Php) M Net Production Value (Php) M Farmgate Price: Php25,000/ton constant Production Cost: Php30,000 per hectare/year (Years 1-2); Php35,000/ha/year thereafter. Labor cost: Php10,500/ha/year (Years 1-2); and Php11,250/ha /year thereafter.

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Development Benefit Streams at economic prices Without Project (Per ha) Year 1 Year 2 Year 3 Year 4 Year 5-25 Harvested area (hectare) 100 100 100 100 100 Yield (ton/ha) 2.5 2.6 2.7 2.8 3.0 Production (ton) Farm Price (Php/ton) 22,000 Gross Prod Value (Php) M Less: Prod Cost (Php) M Labor Cost (Php) M Net Prod Value (Php) M Production Cost/ year: Php30,000/ha/year Labor Cost/year: Php10,500/ha/year Savings in Vehicle Operating Costs (VOC) (With Project and Without Project) Year 1 Year 2 Year 3 Year 4 Year 5-25 With Project Average Daily Traffic* 1 1 4 10 14 Annual Traffic Average VOC per km 50 50 20 20 20 Total VOC Without Project Average Daily Traffic* 1 1 2 3 4 Annual Traffic Average VOC per km 50 50 50 50 50 Total VOC Incremental Benefits *Jeep, light trucks, etc. Summary of Incremental Project Benefits (Php million) Yr 1 Yr 2 Yr 3 Yr 4 Development Benefits VOC Savings Project Cost O&M Cost Net Incremental Benefits

Yr 5-25

Questions: 1. What is the EIRR of the road improvement project? 2. If the development benefit is cut in half, what is the EIRR? 3. What do you think are the direct and indirect financial benefits of the project?

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CASE 3. MULTI-BAND PROJECT

The Akinyan Republic is a large country. Its national telecom agency desires to modernize the government ICT infrastructure under a public-private partnership. The project is expected to link 80 provinces, 100 cities, and 1,600 municipalities. It will have large multiplier effects on the economy. The government currently spends at least US$25 million in annual telecom fees to private sector providers. The project is expected to dramatically reduce the amount. The project has two interested parties ABC Holdings, controlled by the DiCuenta Family; and XYZ Group, controlled by the De Abono Family. ABC Holdings first submitted an unsolicited bid for US$250 million (M). It will fully fund the project from private financing under the BOT (Build-Operate-Transfer) Law. The BOT Law is first in Central Africa. ABC claims it is cheaper as it will use the backbone of the major private telco firms. Some 80% of the costs will be imported equipment. The revenues for the project will be paid by the government over 20 years at the rate of US$32 million a year. The government payment will be derived from annual savings of payments for various telecom services. It also expects to receive corporate taxes at 30 percent of income. XYZ Group. When the Abono group heard about the proposal, it formed a joint venture (JV) with XYZ Ltd. The JV submitted a counterproposal valued at US$400 M The cost will comprise of: US$300 M in imported equipment, and US$60 M in engineering design and project supervision. Some US$45 M are local costs. The sensitive equipment parts will be imported from Israel and then assembled in China. The project will be financed by a government loan (Renminbi RMB 2,800 M) from TRC ExIm Bank, at 3 percent interest a year, with a grace period of 5 years, and principal and interest payable over years 6-20. The annual amortization after the grace period will be US$34 M at the current exchange rate, and the interest payment during the grace period is US$12 M for 5 years. It is estimated that the US dollar will depreciate versus the RMB at the rate of 5 percent a year over the next five years.

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Project Costs (US$ M) Local 0 5 3 5 13 5 18 ABC Proposal Foreign Total 200 200 5 10 7 10 15 20 227 240 5 10 232 250 XYZ Proposal Local Foreign Total 300 300 5 15 20 5 25 30 10 20 30 20 360 380 5 15 20 25 375 400

Equipment Installation Design and Engg Supervision Sub total Contingency Total

Reports indicated by competing quarters indicate: The ABC BOT proposal is better as there is no front-end outlay from the government. The NPV of the government payments at 12% discount rate is US$240 M. However, XYZ claims that the ABC proposal is ampao and lutong macao. The coverage is inferior and the equipment is of poor design and quality the reason why it is cheaper. ABC countered that the XYZ proposal is a bloated pancit canton. Meanwhile, the Akinyan Business Club claims that the government will have to pay US$570 M in principal and interests for the XYZ option.

The Akinyan Parliament decided to launch an investigation and asked for SBEP Consultants, a leading management and economics group, to undertake due diligence. Questions: 1. Compare and contrast the two proposals on the basis of financial criteria (NPV and Risk analysis). 2. Assuming equal economic benefits stream of Php1,800 million a year from Year 3 to Year 20, which is the better proposal in terms of EIRR? (Use forex premium of 20%). 3. Are there certain information in the case that are missing?

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CASE 4. RICE IRRIGATION OPTIONS

The global rice situation has generated intense interest in expanding rice areas and enhancing farm productivity. Today (2011), the Philippines consumes nearly 32,000 tons of rice per day. At 95 million people, this works out to 120 kilograms (kg) per capita, up from only 100 kg per capita ten years ago. The Philippines is one country tat defies global trends: per capita rice demand is rising insread of falling. The Philippines has been a net rice importer since the Spanish era. Export has always been an unusual event. The high rice prices in the world market and, in turn, in the domestic market is a convergence of many events, particularly the low global stocks, climate change, shift to biofuel crops (which caused wheat/bread prices to increase and induced shift to rice) and commodity speculators. Undoubtedly, the sharp rise in world prices has changed the rice economics equation. A team of SBEP alumni is tasked with project analysis by President Aquino. 1. Does it make sense to construct new irrigation systems? or just 2. Restore existing systems. The current world price is at US$500 per ton, but its long-run price (2011 onwards) should be about U$550 in real terms. The price structure is as follows: Rice Price Structure
Item In US$/ton Thai rice, FOB Bangkok + Freighg and insurance CIF Manila Forex (Php:US$1) In Php/ton CIF Manila + 50% Tariff + Handling = Wholesale Price - Transport to trade center - Milling cost net of by products - Trading margin, etc. = Ex-mill price, Central Luzon Palay equivalent (0.65) - Transport (farm-mill) Est. Farm gate price Actual farmgate price (dry) Financial 500 50 550 42 23,100 11,550 2,000 36,650 1,000 500 5,500 29,650 19,273 500 18,773 16,000 Economic 500 50 550 50 27,720 0 1,800 29,520 900 450 4,950 23,220 15,093 400 14,693

With the project, the irrigation area will provide two harvests a year (or 200% cropping intensity). Option 1: New Irrigation System

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With Project : Irrigated: two harvests a year (200% cropping intensity) Without Project: Rainfed: Only one harvest a year (100% intensity)

New Irrigation System (Per Hectare) (In Pesos unless otherwise indicated
1 With Project Crop Area (ha) Yield (ton/ha) Econ. Farm Price (Php/ton) Gross Prod Value (GPV) (Php) Cost (Php) Materials(Php) Labor(Php) Total Cost (Php) NPV (Php) Without Project (Rain fed) Crop Area (ha) Yield (ton/ha) Econ Price ( Php /ton) GPV (Php) Materials(Php) Labor (Php) Total Cost (Php) Net Prod Value (Php) Incremental Benefits(Php) Project Costs O&M Costs Net Inc. Benefit 2 Year 3 4 5 6 7-25

2.0 26,000

2.1

2.2

2.6

3.1

3.6

4.1

20,000 10,000

20,000 10,000

22,000 10,000

26,000 10,000

27,000 13,000

29,000 14,000

30,000 15,000

1 2.0 26,000

1 2.1

1 2.2

1 2.3

1 2.4

1 2.5

1 2.5

20,000 10,000

20,000 10,000

22,000 10,000

22,000 10,000

23,00 10,000

25,000 10,000

25,000 10,000

150,000 0

100,000 0

50,000 0

3,000

3,000

3,000

3,000

Option 2: Restore an Existing Irrigation System -With Project: Two harvests/year (180% cropping intensity, exactly 1.8x harvests a year) -Without Project: Two harvests/year (130% cropping intensity, 1.3x harvests a \year)

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Irrigation Restoration (Per Hectare) (In Pesos unless otherwise indicated)

Per Hectare With Project Crop Area (ha) Yield (ton/ha) Econ. Farm Price (Php/ton) Gross Prod Value (GVP) (Php) Cost Materials Labor Total Cost (Php) Net Prod Value (PhP) Without Project Crop Area (ha) Yield (ton/ha) Econ Price (Php/ton) GVP (Php) Cost (Php) Materials Labor Total Cost (Php) Net Prod Value (Php) Incremental Benefits (Php) 1 2 3 Year 4 5 6 7-25

2.5 26,000

2.6

3.0

3.3

3.6

3.9

4.2

25,000 25,000 26,000 28,000 29,000 30,000 30,000 10,000 10,000 11,000 12,000 13,000 14,000 15,000

2.5 26,000

2.6

2.7

2.8

2.9

3.0

3.0

25,000 25,000 25,000 25,000 25,000 26,000 26,000 10,000 10.000 10,000 11,000 11,000 11,000 11,000

Project Costs (Php) 60,000 O&M Costs 0 Net Incr Benefit (Php) * Every 5 years thereafter

3,000

60,000 3,000 3,000

* 3,000

To do: 1. Compute the IRR of both options 2. Which is a better use of scarce resources: to build a new system or restore existing ones? 3. At what rice farm will the EIRR of each settle at 15 percent?

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CASE 5. SUGAR INDUSTRY PROJECT

Central Mindanao hosts a sugar mill that serves some 10,000 hectares (ha) of farmland within its 30-kilometer (km) radius. The mill employs about 300 workers and managers, while the 2,000 farms employ about 10,000 workers. It is under threat from low world prices (due to rich worlds subsidy) as well as low productivity and efficiency. Due to low productivity and relatively high cost of labor, a large part of the Philippine sugar industry is not competitive in the world market. Its cost in raw sugar basis is about UScents 35/kg, ex-mill. By the contrast, the prevailing world price was about UScents 30/kg till 2006. Lately, world sugar prices dramatically rose to over UScents 50/kg which pushed local sugar prices to the highest levels (at one point in late 2010 to over UScents 100/kg). Some experts believe that this is only a two- to three-year situation and not sustainable. World prices will again fall to its 2006 level of about US cents 30/kg. Below are the long-term financial and economic price structures: Financial Economic Item Price Price Remarks In US$/ton CIF Manila port 270 270 Forex rate 42 50 20% forex premium In Php/ton CIF Manila 11,340 13,608 + Tariff 4,309 0 38% + Handling, etc. 1,500 1350 Conversion factor (Cf) = 0.9 + Mark-up 1,715 1496 10% = Wholesale 18,864 16,454 Price - Transport 1,000 900 Cf = 0.9 = Millgate price 17,864 15,554 In Php/50 kg 893 778 bag, millgate The Threat. Under the ASEAN Free Trade Area (AFTA) Common Effective Preferential Tariff commitment, the tariff on sugar will fall to 5% in 2014 from 38% in 2010 Below are related facts for sugar farming: 1. Yield: 60 tons cane per ha (plant crop) 2. Sugar recovery: 2 bags of 50 kg (LKG) per ton cane 3. Sharing of sugar: 70% planter and 30% mill 4. Farm production costs: unskilled labor - 100 man-days at Php200/day; Material costs - Php60,000 per ha (60% imported component) 5. SWR factor: 0.60 Forex factor: 1.20 Questions:

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1. Will the industry in the region survive with 5% tariff in 2014? 2. How much should productivity increase to make it survive? Plan B What if the farmers shift to hybrid corn at 2 crops per year? Are they going to be better off? Is this a practical solution or a partial and risky one? Use the following data: 1. Yield/harvest: 5 tons/ha 2. Farm price: Php12/kg 3. Farm Production costs - labor: 60 days at Php150/day; material costs P30,000/ha Assume that the financial/market values are identical to economic values. Plan C The Bio Fuels Act mandates E10 gasoline in the Philippines. Present demand needs 10 or so ethanol plants. The Law, however, mandates that the plant should be built at some distance from an existing sugar mill in order not to deprive the latter of raw materials. With the recent rise in sugar prices came higher prices of cane. This led to closure of several ethanol plants. Plan C is a non-starter at this time.* Case under review.

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CASE 6. PORT CARGO HANDLING PROJECT

The project involves the installation of cargo-handling equipment. The cargo, about 140,000 tons a year, is now being handled by manual labor. The benefits with project are: faster unloading of ships which reduces their turnaround time and allows greater port utilization and reduction in labor costs. Cost and Economic Life (In thousand rupees, unless otherwise stated) Annual Operating Capital Costs Costs Item Forklifts (10) 1,650 255 Tractors (7) 600 120 Trailers (54) 750 15 Pallets (2,375) 2,100 90 Total 5,100 480 Note: Numbers in parenthesis are number of units Reduced Ship Turnaround Time The actual increase in handling rate could be as high as 60 percent, but given different types of cargo, an improvement of 25 percent might be reasonable. This does not lead to an equivalent 25 percent reduction of the time of ships in the port because ships work only 16 hours a day, six days a week, and time is lost in bringing ships alongside, opening and closing hatches, starting work late and quitting early, and so forth. The savings in turnaround time are estimated at half the 25 percent rate, or 12.5 percent. The present average turnaround time at berth is 94 hours per ship. A saving of 12.5 percent is 11.7 hours per ship. The average number of ships at berth per year is about 75. The total annual savings is about 880 hours. The value per hour (mostly in foreign exchange) is Rs1,500, so that the total annual benefit is Rs----. (please compute). Increased Berth Capacity The reduction in turnaround time also allows more ships to dock. The value of additional capacity depends on the port situation. Additional capacity of any form is not required for about two years because of the recent expansion in capacity from the new equipment, physical expansion can be postponed for a year. Since the additional berth would cost about Rs18 million, a delay of one year at an opportunity cost of capital of 12 percent gives a benefit of about Rs2.16 million in the 3rd year. Reduction in Labor Costs The cargo handling equipment might lead to reduction in labor force. The labor cost of cargo handling is about Rs21 per ton. For the increased annual output of 35,000 tons (25 percent of 140,000 tons), this is a saving of Rs 735,000. Since labor is mostly

Economic Life (years) 8 12 12 4

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unskilled, the shadow wage rate is 50 percent. The economic cost of labor is Rs -----(please compute). Costs and Benefits: Cargo Handling Equipment (in Rs 000)
Costs Year Capital Operating Total Benefits Reduced Increased ship berth Labor time cap. saving Net Total

1 2 3 4 5 6 7 8 9 10 11 12 13 To do:

5,100

480

1,320

368

1,688

1. Compute for the IRR and NPV at 12 percent 2. What happens to the IRR and NPV if the annual time savings in ship turnaround falls by 30 percent? A problem: the labor union has lodged a complaint that the operator is connected to the powers that be and will not execute the project as planned. Its intention was only to replace the prevailing high cost of labor.

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CASE 7. BUSINESS EDUCATION PROJECT*

The government of the Republic of South Islands is considering the establishment of a new department of business management at one of the countrys better known universities - University of Pacific Islands (UPI). Surveys of the employers of the region where UPI is located reported a severe shortage of business management graduates and managers. This has affected investments in tourism, fisheries and services. It is planned that after four years, there will be eventually 400 students in the program in various specialties: supply chain management, business economics, hotel and restaurant management, business IT, and accountancy. Data showed that the additional income that locally employed graduates of such courses could expect to earn would be about M$190,000 a year after graduation. The lost income of a high school graduate will be about M$20,000 a year while the living expenses of each student will be M$5,000. Altogether, these will average M$25,000 per year per student. The government will spend for the infrastructure (buildings and equipment) and teachers salaries. However, it expects to benefit from: (a) skilled graduates, and (b) government tax on salary income of 33%. PROJECT COST (M$ 000) Buildings and Equipment Faculty salaries Administration Other costs Total Government Costs Year 1 100,000 0 0 0 100,000 Year 2 30,000 11,200 200 50 41,450 Year 3 onwards 0 12,400 400 100 12,900

Assume that the financial cost is identical to economic cost. Calculate the following NPV (at 10% hurdle rate) and IRR: 1. Economic 2. Private (Financial) 3. Private Individual (Financial) 4. Government (Financial) What if: 1. Building cost increases by 20 per cent? 2. Additional salaries of graduates fell by 20%? Estimate the impact on the economic and private returns.

Adapted from: Frances Perkins, Practical Cost-Benefit Analysis, MacMillan Education Australia .1994.

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BUSINESS EDUCATION PROJECT TEMPLATE (In M$000) 1 COSTS Buildings Faculty salaries Admin Other costs Total Govt Costs Total Private Costs @M$25,000/student/yr TOTAL ECON COSTS BENEFITS Additional income per student, MP190,000/yr No of students/year Total graduated Total extra income Income tax rate (33%) Tax Revenue Calculate: Net Economic Benefits Total Net Private Benefits (after tax) Individual net private benefits (after tax) Net government financial benefits 2 3 Year 4 5 6 7 8-40

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Annex: Key tasks for design and review

Formulate the without-project scenario in the financial and economic analysis, taking into account underlying trends in technology, policy, local economy and physical environment in the project and wider system area, in order to reflect changes in productivity (positive or negative) that would have occurred without the intervention. For the with-project scenario in economic analysis, check for possible substitution effects to determine net incremental output and impact. For the financial analysis, present appropriate measures of the attractiveness of the investment. Return to capital calculations can be supplemented with returns to labor and land. Check the assumptions underpinning the enterprise models with regard to availability of inputs, labor, and when relevant- access to credit. Examine the distribution of incremental benefits and incremental private costs along the value chain in order to arrive at realistic producer prices. Undertake economic analysis using standard shadow pricing methods for the adjustment of financial prices and the elimination of transfer payments to reflect the economic prices of resources. Extend shadow pricing to estimate significant non-marketed project outputs and impacts. Calculate rates of return at the level of the whole project where the total cost of infrastructure, agricultural development, irrigation, and other hard investments, is dominant in the cost tables. The analysis will be more informative if rates of return are also calculated separately per component and/or a combination of them. Test key project assumptions and risks using sensitivity and risk analysis. At the enterprise level, important parameters for testing are variability of yields and seasonal price volatility; and at the project level implementation delays and availability of counterpart financing (especially the projected contributions from targeted communities and government institutions to meet O&M and other recurrent costs; and donor co-financing for critical investment components). Use switching values for sensitivity analysis, and justify the choice of scenarios examined.

Source: IFAD (http://www.ifad.org/rural/learningnotes/cci/5.htm)

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