Economic Analysis Concepts

Questions & Decisions (1)

Is the project justified ?- Are benefits

greater than costs?

Which is the best investment if we have a

set of mutually exclusive alternatives?

If funds are limited, how should different

schemes be ranked?

When should the road be built or

upgraded?

Questions & Decisions (2)

What standard of construction

should be used?

What standard and frequency of

road maintenance is optimal?

Should staged construction be used?

Are complementary investments
required?

Appraisal Framework

All appraisals need a framework

model for:

a) Forecasting changes
b) Evaluating those changes

or

Components of Economic Analysis (1)

Costs and benefits are measured in

money

terms

Road construction and maintenance costs

are compared with estimates of the direct
primary benefits going to road users and
road agency

Secondary benefits are usually ignored

Economic prices are used in constant terms

Components of Economic Analysis (2)

Costs and Benefits are forecast over

the planning time horizon (usually
between 10 and 20 years)

Future Benefits are valued less as

time progresses using the planning
discount rate

Costs and Benefits are compared

using decision criteria such as NPV,
IRR, etc.

Economic and Financial Prices

The cost to the economy of road
rehabilitation and maintenance may differ
from the financial cost because of :
taxes and duties
shortage of foreign exchange
under-employment
The Government will usually be concerned with
ECONOMIC costs.
Contractors will usually be concerned with
FINANCIAL costs.

Use of Economic Prices

In an Economic Appraisal we use ECONOMIC
(or SHADOW) prices NOT FINANCIAL prices
Adjust financial prices as follows:
Exclude all taxes and duties and subsidies
Use the planning discount rate not financial market rate
If overvalued exchange rate then value imports and
exports more highly
Use the opportunity cost of labor
Standard Conversion Factors are now widely used for
road construction costs

Benefits from Road Investment

Changes in transport costs occur because of
:
Lower road roughness
Shorter trip distance
Faster speeds
Reduced chance of impassability
Reduced traffickability problems
Change in mode

Project Costs

Management (including design and

supervision)

Labor
Equipment
Materials
Land, Resettlement, Environment

Primary Effects (1)

Reduced vehicle operating costs (VOC)

fuel and lubricants
vehicle maintenance
depreciation and interest
Tire wear
Crew time
overheads
Reduced journey time
drivers, passengers and goods

Primary Effects (2)

Changes in road maintenance costs

Changes in accident rates
Increased travel
Environmental effects
Change in value of goods moved

Secondary Effects

Changes in agricultural output

Changes in services
Changes in industrial output
Changes in consumers behavior
Changes in land values
Changes in income

Consumers Surplus Approach

Captures primary benefits

Advantages: Simple, cost based, traffic

approach dependent on predicting

changes in traffic
Disadvantages: May not address critical
factors promoting either rural
development or social access

Normal and Generated Traffic Benefits

Total Benefits

Transport cost savings to

Normal traffic and growth

Cost

+
Additional benefits to
Generated traffic

C1

C2
Demand Curve
(Price Elasticity of Demand)
T1
Normal

T2
Generated

Traffic

Generated Traffic Benefits

Traffic induced by the road investment are
traditionally valued at:
Half the difference in transport costs
Hence total generated transport cost benefits
= Generated Traffic Volume x Change in
Transport Costs per km x Distance x 1/2

Producers Surplus Approach

Captures secondary benefits
Advantages: Draws attention to changes in

agricultural output (key economic activity in rural

areas)
Disadvantages: No reliable way of predicting response
- impact studies give widely different answers
- it could be based on agricultural supply price
elasticities but this is almost never done; it requires
very careful examination to use.
For most projects benefits are just invented !

Producers Surplus
Price & Costs per Unit
of Output

Increased
Farmgate Price

P2
P1

Lower Input Costs

Output

O1

O2

Coverage and Double Counting

Any economic analysis should be designed

to give maximum coverage of benefits

But we must avoid double counting. Do not
add primary and secondary benefits (e.g.
changes in land values added to changes
in transport costs)
In a competitive economy the consumers
surplus approach (used in HDM) should be
adequate

Economic Comparisons

Economic analysis involves a comparison of

With and Without project cases

Forecasts are made of traffic, road condition,

VOC and road maintenance effects for BOTH
scenarios

An unrealistic Without case (i.e. with little

maintenance) can give a false result

A range of

With investment cases should be

analyzed to find the best solution

Traffic Categories

Normal traffic: Existing traffic and growth that would

occur on road, with and without the investment

Diverted traffic: Traffic diverted from another road with

same origin and destination to as the project road as a
result of the investment

Generated traffic: Traffic associated with existing

users of the road driving more frequently or driving
further than before

Induced traffic: Traffic attracted to the project road due

to increased economic activity in the roads zone of
influence brought about by the project

Benefits from Road Investment

Transport cost savings for existing (or normal)
traffic = Normal Traffic Volume x Change in
Transport Costs per km x Distance
Main changes in cost from:
a) change in transport MODE
b) reduced journey TIME
c) reduced VOCs

Benefits of Upgrading to a
Motorable Track
Headloading
C1
Track

Costs

Improved
road
C2
C3
T1

Traffic

T2

T3

Cost Effectiveness Against

Standard of Road

Development Benefits
Development benefits arise from a
combination of increased traffic and
reduced transport costs.
Benefits may also include :
Increased agricultural production
Increased service provision
Increased industrial activity

Estimating Benefits
Normal traffic benefits:

trips N * d1 * (VOC1- VOC2)

Diverted traffic benefits: trips D * ((d1 * VOC1)-(d2*VOC2))

Generated and Induced traffic benefits: trips G * d2 * (VOC1VOC2)/2
d1
= existing road length
d 2 new road length
VOC1 = vehicle operating costs per km without investment
VOC2 = vehicle operating costs per km with investment
VOC data relates to each road section and its condition at
the time

Economic Decision Criteria (1)

Net Present Value

NPV = (B1- C1)/(1 + r) + (B2- C2)/ (1 + r)2 + + (Bn- Cn)/(1 + r )n

Internal Rate of Return

To calculate IRR, solve for r, such that NPV =
0
B1, B2Bn = Benefits in years 1, 2 n
C1, C2Cn = Costs in years 1, 2 . n
r
n

= Planning discount rate

= Planning time horizon

Economic Decision Criteria (2)

Net Present Value/ Investment Cost
NPV/ C = NPV/Ci

First Year Rate of Return

FYRR

= (B1- C1) / Ci

B1 , C1

= Benefits and Costs in year 1

after construction
= Road investment costs

Ci

Payback Period

Economic Decision Criteria (3)

NPV

IRR3

NPV/C FYRR

Project economic validity

V.Good

V.Good

V.Good

Poor

Mutually exclusive projects

V.Good

Poor

Good

Poor

Project timing

Fair

Poor

Poor

Good

Project screening 1

Poor

V.Good

Good

Poor

Under budget constraint 2

Fair

Poor

V.Good

Poor

Notes:
1. check for robustness to changes in key variables (sensitivity analysis)
2. with incremental analysis
3. IRR may be indeterminate with NONE or MANY solutions.

Present Value Calculation

Period Flow
0
1
2
3
4
5
6
7

A0

A5

PV(A0) = A0

PV(A5) = A5 / (1 + i ) ^ 5

PV(Aj) = Aj / (1+ i ) ^ j
PV(Aj) = Present Value of Aj
Aj = Amount at year j
i = Discount rate
j = Year

Present Value at 12.0% Discount Rate

in

Year 1 =
Year 2
Year 3
Year 4
Year 5 =
Year 6
Year 7
Year 8
Year 9
Year 1 0 =

1.00 in Year 1
0.89
0.80
0.71
0.64 in Year 1
0.57
0.51
0.45
0.40
0.36 in Year 1

1.00

in

Year 15 =

0.20 in Year 1

1.00

in

Year 20 =

0.12 in Year 1

1.00

in

1.00

in

1.00

Discount Rate

The discount rate is opportunity cost of

capital in the public sector, ie the rate of
return on marginal public sector investments
The discount rate to be used will be given by
the planning authority responsible for the
project
The World Bank traditionally has not
calculated a discount rate for each project
but has used 10 to 15 percent as a notional
opportunity cost of capital in developing
countries

Discount Rate Versus Interest Rate

US discount rate around 4%

NPV and IRR

The Net Present Value (NPV) of a

project alternative relative to the without

project alternative is the sum of the
discounted annual net benefits.

The Internal Rate of Return (IRR) is the

discount rate at which the NPV is zero.

NPV Decision Rule

1. If the NPV is positive, for the chosen
discount rate, then the alternative is
acceptable.
2. If the NPV is negative, for the chosen
discount rate, then the alternative is
unacceptable.
3. If the NPV is zero, for the chosen
discount rate, then the alternative is
indifferent to the without project alternative .

NPV and IRR Calculation (1)

Discount
Rate (i)
12.0%
Investments
Profits
or
or
Year
Costs Benefits
a
b
c

Discount
Rate (i)

Present
Net
Value
Benefits
Factor
d = c-b e = 1/(1+i)^a

Present
Value
f = d*e
-10000
5804
2392
2135
3178

0
1
2
3
4

10000
0
0
0
0

0
6500
3000
3000
5000

-10000
6500
3000
3000
5000

Total

10000

17500

7500

1.0000
0.8929
0.7972
0.7118
0.6355

3508
NPV =

3508

IRR =

29.3%

0.0%
3.0%
6.0%
9.0%
12.0%
15.0%
18.0%
21.0%
24.0%
27.0%
30.0%
33.0%
36.0%
39.0%
42.0%
45.0%
48.0%

Net
Present
Present
7500
6326
5281
4347
3508
2752
2068
1447
881
365
-109
-544
-944
-1315
-1657
-1975
-2271

NPV and IRR Calculation (2)

NPV Versus IRR

- The IRR and NPV will not necessarily rank the alternatives by the same order
- Always use NPV to compare project alternatives

Multiples Rates of Return

Discount
Rate
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
24%
26%
28%
30%

NPV
-10.0
-6.9
-4.4
-2.5
-1.0
-0.0
0.6
0.9
0.9
0.6
0.0
-0.8
-1.8
-3.0
-4.4
-5.9

Multiple Rates of Return

2.00

0.00
0%
Net Present Value (M$)

Year
0
1
2
NPV at 12%
IRR #1
IRR #2

Net
Benefits
-500
1150
-660
0.64
10%
20%

5%

10%

15%

20%

-2.00

-4.00

-6.00
-8.00

-10.00

-12.00
Discount Rate (%)

25%

30%

35%

No Rate of Return
Year
0
1
2
NPV at 12%
IRR

Net
Benefits
200
300
350
747
#NUM!

No Rate of Return
900
800

Discount
Rate
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
24%
26%
28%
30%

NPV
850.0
830.5
812.1
794.5
777.8
762.0
746.9
732.5
718.7
705.6
693.1
681.1
669.6
658.6
648.0
637.9

Net Present Value (M$)

700
600
500
400
300
200
100
0
0%

5%

10%

15%

20%

Discount Rate (%)

25%

30%

35%

Same Rate of Return

Incremental Rate of Return

Alternative A - Base
Investments
Profits
or
or
Year
Costs Benefits
0
1

8
0

0
16

Alternative B - Base
Investments
Profits
or
or
Year
Costs Benefits
0
1

100
0

0
120

Alternative B - Alternative A
Investments
Profits
or
or
Year
Costs Benefits
0
1

92
0

0
104

Net
Benefits
-8
16

Net
Benefits
-100
120

Net
Benefits
-92
104

Present
Value
Factor
1.00
0.89

Present
Value
Factor
1.0000
0.8929

Present
Value
Factor
1.0000
0.8929

Present
Value
NPV =
6.3
-8.0 IRR = 100.0%
14.3 MIRR = 100.0%
B/C =
1.79

Present
Value
NPV =
-100.0 IRR =
107.1 MIRR =
B/C =

7.1
20%
20%
1.07

Present
Value
NPV =
-92 IRR =
93 MIRR =
B/C =

0.86
13%
13%
1.01

IRR Reinvestment Assumption

IRR IMPLICIT ASSUMPTION:
ALL CASH FLOW VALUES WILL EARN THE IRR INTEREST RATE
Discount
Rate (i)
12.0%
Investments Profits
or
or
Net
Year
Costs Benefits Benefits
a
b
c d = c-b
0
1
2
3
4

10000
0
0
0
0

0 -10000
6500
6500
3000
3000
3000
3000
5000
5000
NPV=

Future Value in Year 4

If You Receive
and Invest at
29.3%
Interest

If You
Invest at
29.3%
Interest
10000
12929
16715
21611
27940

6500
8404
10865
14047

3000
3879
5015

3000
3879

3508
Total 27940

IRR=

29.3%

5000

Modified Internal Rate of Return

Modified Internal Rate of Return Calculation
Financing
Rate (i)
12.0%

Year
a
0
1
2
3
4

Net
Benefits
d = c-b
-10000
6500
3000
3000
5000

TOTAL

7500

NPV =
IRR =

3508
29.3%

MIRR =

20.7%

Costs
10000
0
0
0
0

Reinvestment
Rate (i)
12.0%

Present
Value
of Costs
at Year 0 Benefits
10000
0
0
0
0
10000

0
6500
3000
3000
5000

Future
Value
of Benefits
at Year 4
0
9132
3763
3360
5000

Modified
Cash
Flow

-10000
0
0
0
21255

21255
3508
20.7%

Benefits X Cost
120

100

Alternative B

Benefits

80

60

40

20

Alternative A
0
0

20

40

60

Costs

80

100

120

Net Benefits X Costs (Efficiency Frontier)

8
7
Alternative B

Net Benefits (NPV)

6
5

Alternative A

4
3
2
1
0
0

20

40

60

Costs

80

100

120

Comparison of Alternatives

When comparing project-alternatives,

the Net Present Value (NPV) is used

to select the optimal project-alternative
(alternative with highest NPV)
The Internal Rate of Return (IRR) or
the B/C ratio are not recommended to
compare alternatives of a given project

Projec
t

Alternatives NPV
0.0
3.7
6.7
5.5

Optimal
Alternative:
Highest NPV

Ranking Projects

When comparing the economic priority

of different projects, a recommended
economic indicator is the NPV per
Investment ratio

Project
s

Selected
Alternative

NPV/Investment
8.4

Overlay
5.2
Reseal
2.1
Overlay

P
R
I
O
R
I
T
Y

Budget Constraints Simple Methodology

Projects

Selected

NPV

Investme
nt

NPV per
Investme
nt

2.0

8.4

3.0

5.2

5.0

4.0

Alternativ
e
16.8
Overlay
15.6
Reseal
20.0

Available Budget
Overlay

3.0

Budget 2.0
Constraint 1.5
Cut Off

Reseal
5.0

P
R
I
O
R
I
T
Y

Budget Constraints Optimization

Projects Alternatives NPV
0.0
3.7
6.7
5.5
0.0
2.0
1.0
3.5
Available Budget

0.0
5.4
2.1
3.2

Evaluates all possible

combinations of projectalternatives to find the
combination that maximizes
the NPV of the overall
network for the given budget
constraint.
P = Number of projects
A = Number of alternatives
C = Number of possible
combinations
C =A^ P

HDM-4 Optimization Example (1)

Section 1
Option
A
B
C
Section 2
Option
A
B
C

Cost

NPV

2
5
7

4
7
8

Cost
1
3
5

NPV
3
6
8

What is the recommended program for a budget of 5?

HDM-4 Optimization Example (2)

9

6
5
4

dNPV/dCost

2
1
0
0

Cost
Section 1

Section 2

HDM-4 Optimization Example (3)

18
16

1-C, 2-C

14

1-B, 2-C

12

1-A, 2-C

10

1-A, 2-B

8
6

1-A, 2-A

4
2
0
0

Combination of project alternatives

that maximizes the NPV of the
network

8
Cost
Network

10

12

14

Appraisals & Post Evaluations (1)

An Appraisal is carried out before an

investment is made. Everything is

uncertain.
A Post evaluation may be made say 5 years
after the investment. The investment is
known and 5yrs of with case are known.
The without case is unknown as is the
remainder of the with case.

Appraisals & Post Evaluations (2)

In Both Cases forecasting and

evaluation models are required to come

to an answer.
Hence we can never be certain about
the viability of an investment !

Sensitivity Analysis

Consequences of changes on inputs

Investment Costs (e.g. +15%)

Traffic Growth Rate (e.g. = zero)
Generate Traffic (e.g. = zero)
Value of Time (e.g. = zero)

A = Investment Costs Increase (e.g. +15%)

B = Road User Benefits Decrease (e.g. -15%)
C = A and B together

Switching Values Analysis

Inputs that yield a NPV equal to zero

Investments Costs
Normal Traffic
Traffic Growth Rate
Generate Traffic
Investment Cost
Road User Benefits

Risk Analysis
Inputs vary at the same time
following some defined
distributions

Rural Transport Infrastructure

Tracks

Roads

Highways

Rural Transport Infrastructure

Focus on social evaluation (cost effectiveness

indices, community priorities and multi-criteria
analysis)

Social Benefits: Why the Concern ?

There is unease with conventional appraisal based primarily on

transport cost savings to traffic
There is a strong desire at community and national levels for
better access and mobility which is frequently not matched by
standard measured economic benefits
The rich world governments subsidise rural transport. Should
the same happen for developing countries ?
Isolation is a recognised characteristic of poverty
There is a feeling that a minimum degree of access and
mobility is a basic human right
Development has moved away from a narrow definition of
economic development towards concern with livelihoods and
meeting Millennium Development Goals
The issue is particularly important when roads are impassable
to motor traffic

Economic & Social Benefits

Consumers and producers surplus approaches are very

economic in orientation. Yet roads provide social benefits
including improved access to health and education facilities
and improved social mobility that cannot be easily translated
into conventional economic benefits. Although they may
have important long term economic consequences. Improved
health and education and more secure social networks
increase long term earning capabilities but so far the
economic forecasting framework does not include this.

When roads are impassable to motorized traffic we know that

the quality of health care and schooling falls. Drug supply and
supervision drops. Likewise no NGO, government agency or
commercial enterprise will establish or support a service which
cannot guarantee all year round access.

Indices and Ranking

Widely used for feeder road planning; there are many

different approaches
e.g. i) cost of improvement / population
ii) estimated trips / cost

Advantages: Speed , simplicity, transparency, many factors

can be incorporated
Disadvantages: How do we value widely different factors ?
(adding up apples and pears); weightings are not stable ;
cannot easily address questions of road standards, timing
etc, ; possible double counting

Example of Two Indices

i) Andhra Pradesh (India)
cost effectiveness = cost of upgrading/ population served
But no measure of condition change and no importance to traffic
ii) Airey & Taylor
1st for impassable roads
rank
= cost per head of establishing basic access
2nd when access is there:

prioritization index

estimated trips x access change

= -------------------------------------------rehabilitation cost per km

Community Priorities

Community priorities now often form an important part of

feeder road appraisal. It is possible just to ask communities
to rank the investments they prefer- both within the road
sector or between roads and other investments.
Advantages: Community acceptability, use of community
knowledge
Disadvantages: Sectional interest groups may dominate
voting, community knowledge of area or road impact may
be poor

Cost Effectiveness Analysis (CEA)

Compares the cost of interventions with its

predicted impacts and it is used where the
benefits cannot be measured in monetary
terms, or where the measurement is difficult
It includes provisions that (a) the objectives of
the intervention are indicated and are clearly
part of a ampler program of objectives (such as
reduction of the poverty); and (b) the
intervention represents the smaller cost
alternative of obtaining the indicated objectives
It produces effectiveness indicators, such as
Total Beneficiary Population per Investment or
Investment per Beneficiary Population

CEA Comparison of Alternatives

To compare project-alternatives, the investment

cost is used to select the optimal alternative
The selected alternative is the one with the
lowest investment cost that will achieve the
objective of the program
Alternatives Investment
2.0
Project
Optimal
3.7
Alternative:
1.7
Lower Investment
5.5

Projects Eligibility with CEA

To assess if a project is eligible, an acceptable

effectiveness indicator threshold is defined
Investment per
Population
(U$/person)

Projects

50
150
500

Effectiveness
Indicator
Threshold
Example
Eligible
Not Eligible

Effectiveness Indicator Threshold

Evaluate Universe
of Projects and
Available Budget

Possible CEA Indicators

Investment Cost per Total Beneficiary

Population
100 US$ per person

Total Beneficiary Population per

Investment Cost
0.01 persons per US$

Total Beneficiary Population per

Investment Cost in thousands of dollars
10 persons per 1,000 US$

Etc.

Options for Beneficiary Population

Rural beneficiary population

o Effectiveness = (rural beneficiary population) /

Investment

Poor beneficiary population

o Effectiveness = (poor beneficiary population) /

Investment

Mixed beneficiary population

o Effectiveness = (poor persons + 0.3 non poor

persons) / Investment

Etc.

Total Beneficiary Population (1)

Total Beneficiary Population = Directly Benefited
Population + Indirectly Benefited Population

The Directly Benefited Population is the one that lives

next on the road, defined for example to 2.0 km at
each side of the road, and the population in the ends
of the road, depending on its characteristics and the
use of the road
The Indirectly Benefited Population is the population
that lives in other roads near the road in
consideration, who use the project road to arrive at
the main population center of the region or at a main
road

Total Beneficiary Population (2)

For example, for the road section B-C:

Directly Benefited Population = Population along section B-C plus on
towns B and C
Indirectly Benefited Population = Population along section A-B plus on
town A

Multi Criteria Analysis (MCA) (1)

It adopts criteria such as traffic, proximity to

educative, health, and economic centers, etc.
To each section, a number of the points is assigned
to each criteria that correspond to the fulfillment of
the criteria
The added number of the points that each section
receives is computed simply adding the points
assigned for each criteria, or with the use of a more
complex formula, for example, weighting the criteria
by their perceived importance

Multi Criteria Analysis (2)

It produces a priority indicator

The indicators used in a MCA reflect implicit
economic and subjective evaluations
If the weights and the points are decided and
assigned on a participative way, the MCA has the
potential to be a good participative method for
planning based on implicit a socioeconomic
estimates
Nevertheless, it tends to be applied by planning
consultants or in isolation without the consultation
with the users and communities affected by the
project

Multi Criteria Analysis (3)

The result of the MCA, is often,

unfortunately, not transparent, specially if
many factors are considered and a
complicated formula is also applied
Therefore, if it is adopted, this method
must be used very carefully and to be
maintained simple, transparent, and
participative

Multi Criteria Analysis Example (1)

Level of poverty of the influence area (Low, Medium,

High)
Potential for economic development of the influence
area (Low, Medium, High)
Importance of the road given by local consultation
process (Low, Medium, High)
Provision of access of social services of the road
(Low, Medium, High)
Problems of transitability of the road (Low, Medium,
High)
Functional classification level of the road (Low,
Medium, High)
Existence of public transport (Low, Medium, High)

Multi Criteria Analysis Example (2)

Population
Beneficiary
Population
per km

9,889
520
1,237
564
344
503

Agricultural Area

Poverty

Factor

1.00
0.05
0.13
0.06
0.03
0.05

Poverty
Percent

99%
99%
99%
97%
97%
97%

Factor

1.00
1.00
1.00
0.98
0.98
0.98

Percent
of Area of
Influence

Factor

0%
0%
0%
14%
36%
18%

0.25
0.64
0.32

Priority Index
Functional
Location on Basic
Classification
Network

Traffic
Daily
Traffic
(AADT)

20
20
15
80
15
35

Factor

0.25
0.25
0.19
1.00
0.19
0.44

A=4 B=3
C=2 D=1

1
2
2
3
3
3

Factor

0.33
0.67
0.67
1.00
1.00
1.00

ity Index
Health Centers
Yes = 1
No = 0

0
0
0
0
0
0

Factor

Public Transport

Schools
Yes = 1
No = 0

0
0
0
1
1
1

Factor

Yes = 1
No = 0

1.00
1.00
1.00

Factor = Value / Maximum Value

1
1
1
1
1
1

Factor

1.00
1.00
1.00
1.00
1.00
1.00

Environment
Feasibility
Yes = 1
No = 0

1
1
1
1
1
1

Factor

1.00
1.00
1.00
1.00
1.00
1.00

Priority
Index

5.6
5.0
5.0
7.3
6.8
6.8

Yes = 1
No = 0

1
1
1
1
1
1

Factor

1.00
1.00
1.00
1.00
1.00
1.00