CHAPTER 4

Appraisal of Project Evaluation, Commercial and Social Cost Benefit Analysis

Project Evaluation Methodology

The financial institutions have a detailed appraisal of the project proposal in the following
components:

 Technical Evaluation
 Commercial Evaluation
 Financial Evaluation
 Economic Evaluation
 Management Evaluation
 Government Consents

a) Technical Evaluation

The financial institutions have a closer look at the various technical parameters concerning
the project.

The proposed product range and the technical specifications pertaining to them, the
extent of scrap generation and disposal, etc, should have been spelt out.

It is essential to get information on the process know how and that is available, as also
the basic engineering package and the associated technical services covering the
quality control, pollution control effluent and wastage disposal, collaboration
arrangements for the process licence and the consultant services for detail
engineering.

Plant locational aspects also deserve detailed attention, and include soil testing with
reference to housing, education, health, recreation, etc., infrastructural facilities for
power, water, transport and communication.

Proper scrutiny is needed in respect of the source of supply of plant and machinery,
their quotations, prices, delivery schedules, payment terms, performance guarantee
terms, inspection, post supply services, spares, import licenses, installed and
production capacities, phasing of production, etc,.

Raw material requirements, availability, cost, items to imported, consumables needed

and availability of alternative materials are also factors that have to be ascertained.

Detailed information is also sort on the requirements of building for factory and
office, and arrangements for architecture, service and supplies.

The project team of the financial institution may consult specialist on the technical matters.
Site visits and detailed discussions with the key technical personnel connected with the
project are essential steps in the technical evaluation process.
b) Commercial Evaluation The projected market demands for the products proposed to be
manufactured have to be reviewed and verified for reliability, as they have a critical influence
on the projects viability. The action plans in respect of advertising, sales promotion,
warehousing, and distribution and other relative marketing aspects to be examined.

The market projections in the project could also be cross checked with

 Demand forecast of industry associations;

 The capacity licensed and utilised in the industry;
 Market surveys done on the specific products;
 Forecast of the planning commission
 Projections of the directorate of technical development and other specialised bodies
Where the review establishes the need, the promoter may be asked to revise the
estimates of the cost, time and other technical significant parameters.

c) Financial Evaluation

Financial evaluation has the objective of ascertaining the financial viability of the project by
close scrutiny of the capital cost, operating cost and revenue projections. Following are the
parameters of the financial evaluation of the project:

Debt-equity ratio: the equity shareholding in the total capital structure of the company is
determined by the agreed debt equity ratio. While the institutions have the stipulated norms
for the debt equity compositions for different categories of industries, these are not very rigid.

Promoters’ contribution: The promoter is expected to bring in his share of cost,

representative his financial stake in the project. This is referred to as the promoters’
contribution. The financial institutions stipulate the quantum of such contributions as a
precondition to their project financing. Industries located in the specified categories of
backward areas are eligible for central investment subsidies which get reckoned as part of
equity.

Debt-service coverage: The cash flow represented but the profit after tax but before
depreciation and interest on terms of loans is related to the sum of the instalment due on the
principal and the interest on the term loan outstanding. If the cash flow is 1.5 to 2 times the
total amount due as above, the project is deemed to be sound and viable.

Repayment schedule: Usually, the institutions allow a moratorium of 2 years from the
commencement of commercial production before the repayment of the loan starts. The loan
repayment is generally expected to be completed in 8 – 10 years of the commencement of the
commercial production

Syndication: where a group of institutions participate in financing the project, they come to
an understanding on the proportion in which they will be providing funds.

Conversion: The financial institutions stipulate that they will have a discretion or option to
convert term loan and/or debentures into equity on agreed terms. However, such conversion
will not lead to equity holding of the institutions being in excess of 40% of the companies
issued capital and conversion option will be available only after three years of
commencement of production.

Nominee directors: Nominee directors should be appointed on the boards of all the
companies assisted by the institutions. One or more of the following conditions should be
found to exist for having their nominee directors appointed in such instances

The unit has run into rough weather and is likely to become sick.

The financial institution holds more than 26% of the share capital.

Where the stake of the financial institution by way of loan/ investments exceeds ` crores.

Operating Costs and Revenue: Projects of operating costs and revenues, on an annual basis
have to be made for a 10 year period, which is scrutinised by the project team of the financial
institution. The assumption pertaining to quantities, rates, availability of inputs and services,
market demands, price realisation and expectation of capacity utilisation are all subjected to
close review.

Extent of financing: The amount and modes of financing depend on the nature and size of
the project, the accepted norms in respect of promoter’s contribution, debt-equity ratio, debt
service coverage, etc. besides factors such as the resources of the financial institution and
requirement in respect of listing of securities in the Stock Exchanges

Returns: Financial institution use the different techniques of financial evaluation including
pay-back period, internal rate of return, return on investment etc. depending on the nature of
projects being reviewed. It is expected that the project will have a debt service ratio ranging
from 1.5 to 2 and will be able to pay a dividend on equity of not less than 10 % within three
years of commencement of production

Risks: Careful assessment of the risk is associated with the project is a prime necessity
associated may be industry-specific, particular project, its product, the concerned market
conditions, the company’s capital structure and the nature securities offered by it.

Eventually financial evaluation of project has 4 important aspects

 The appropriateness of the capital cost estimate;

 The reliability of the estimates of the operating costs, revenues and surpluses;
 The adequacy of return on investment to service equity and debt; and
 The matching of financing pattern to the project’s requirements.

d) Economic Evaluation The acceptability of the project from a national perspective also
has to be ascertained. From this stand point, the economic evaluation carries out the social
cost benefit analysis of the project. The financial costs of the various inputs into the project
get converted into social costs with the use of appropriate shadow prices, border prices
(international prices), and so also the financial revenues get restated in terms of social gains
or border prices. While the above bases are adopted for tradable inputs and outputs,
prescribed conversion factors are used for non-tradable items.

Applying the stipulated social rate of discount, the NPV is determined, and if it is positive,
the project is considered to be socially desirable. Discounted cash flow analysis with
reference to social cause and social benefits and determination for the internal rate of return
on these values will give the economic rate of return. If this is in excess of the social rate of
discount, the project merits acceptance.

e) Management Evaluation

Management capabilities that will guide the project need also to be assessed, as this
constitutes the core requirement for project success. Promoter’s past experience in managing
enterprises, financial soundness, technical background, etc., are the factors to be examined
for getting an appreciation of how effective the project management may be. His/her stake in
the project in terms of the capital contributed and commitment to its immediate and long term
goals have to be ascertained. The competence and capabilities of key management personnel
are to be closely looked at. The specific development plans for improving and sustaining the
technical and managerial skills have to be studied and the assignment of project construction
and administrative responsibilities to key project personnel have to be reviewed and
approved. Financial institutions also decide on having their nominee directors on the
company board.

Government Consents

The financial institutions would also insist on confirmation that the various licences are
consents required for the projects have been obtained, among them being:

 Letter of intent
 Industrial licence
 Capital goods clearance
 Import licence
 Foreign exchange permission
 Approval of technical/financial collaboration
 Clearance under MRTP Act
 Consent of the controller of capital issues (SEBI)

Commercial Vs. National Profitability

Public projects like road, railway, bridge and other transport projects, irrigation, projects,
power projects, etc for which socio-economic considerations play a significant part, rather
than mere commercial profitability. Such projects are analysed for their net socio-economic
benefits and the profitability analysis of such projects is known as social or national
profitability analysis which is nothing but the socio-economic cost benefit analysis done at
the national level.
Steps Involved in Determination of Social or National Profitability

1) Real Direct Cost and Real Direct Benefits

National/Social profitability analysis takes into account the real cost of direct costs and real
benefit of direct benefits. For instance, some of the inputs may be subsidized. Only the
subsidized prices of input is what is relevant for assessing commercial profitability. However,
the national profitability analysis takes into account the real cost of inputs i.e. cost of input
had they not been subsidized. Accordingly the required adjustment to direct cost of input are
made for national profitability analysis.

2) Indirect Costs and Indirect Benefits

National/Social profitability analysis takes into account the indirect costs and indirect
benefits to the nation. While a nation bears the indirect cost, the people of the nation enjoy
the indirect benefit. Hence, indirect costs and benefits are given due recognition and
accounted for in social cost benefit analysis. It is however difficult to assess exactly the
quantum of indirect costs and indirect benefits.

Suppose construction of a bridge over a river is taken up. Its indirect benefits may include
improved communication facilities reduction in transportation costs, reduction in traveling
time, etc., while the indirect cost may include acquisition of private land by the state, removal
of industrial, commercial, agricultural activities that prevailed in the land that was acquired,
disturbance of ecological balance etc.

National/Social profitability analysis can thus be regarded as a refinement over commercial

appraisal taking the hidden factors into account. National/Social profitability analysis is
mainly used for evaluating public investment projects. From the society’s standpoint, the
project should maximize the aggregate consumption or the addition to the flow of goods and
services in the economy. While the individual investor looks for maximization on his
individual basis, the society’s interest should look for maximization of the total output of the
economy. The need thus arises to have an analysis done of social costs and social benefits.
The various inputs required for the project are drawn out of the resources of the economy and
constitute social costs. The outputs of the project represent the social benefits. The inputs of
goods and services and the outputs should be valued with reference to their relative value to
society.

Commercial or Financial Profitability

From the national development point of view, there are always more projects compared to
the availability of resources and hence the necessity to appraise projects for selection arises.
While the obvious choice will be the projects with higher returns, the complexity arises
because of the need to appraise projected outcome based on forecasts in a world of
uncertainly, particularly in the context of endemic inflation. In the case of large projects,
particularly public sector projects involving the building up of infrastructure it is essential to
assess the social merits of the investment proposals.
Projects emanate from diverse and dispersed sources, such as individuals firms or institutions,
and government at the state and central levels. In situations where the state government is not
the owner of the business, the traditional yard stick of commercial or financial profitability is
used for selection of projects for implementation. The financial benefits get related to the
financial costs of the project and if there is a net surplus the project merit choice. While the
process of selection of individual projects thus meets the profit criteria of the individual
investors or promoters, the combination of choices may not necessarily result in the most
socials profitable allocation of resources. For developing economies this is the very important
factor but it cannot be ignored.

Commercial or financial profitability as the sole deciding factor has two major limitations
viz.

a) Financial or market values seldom match with social values and

b) What is beneficial to one segment of society may not necessary be so to the entire
society.

In financial analysis the market values of input and outputs are reckoned and compared. And
since market distortions are many, these values fail to reflect the relative worth on the
society’s value scale. From society’s stand point, goods and services should be valued in
terms of relative contributions to consumption. In the same manner the social value of
resource should be reckoned in terms of its opportunity cost, represented by the output or
consumption value that it is capable of yielding in its next best alternative use.

In a free market economy the dominance of the forces of demand and supply has the effect
of the market prices being kept close to social valuation. In a developing economy however
there are several distortions entering into the market prices and they are far removed from
their social valuation. The distortions arise from the monopolistic status of many large
enterprises a system of administered prices in a controlled economy and from various
government policy measures such as taxes, duties, controls and foreign exchange regulations.

A project may confer considerable good to society that does not get reflected in financial
projections. Others though financially very rewarding may have some harmful effects on
society that the financial results fail to interpret. These effects that are outside the purview of
financial projections are known as externalities and are essential ingredients in the social
profitability computations. The emphasis in social cost benefit analysis is the import on the
whole society and not one segment.

Social Cost Benefit Analysis (SCBA)

Cost-benefit analysis is a process for evaluating the merits of a particular project or course of
action in a systematic and rigorous way. Social cost-benefit analysis refers to cases where the
project has a broad impact across society and, as such, is usually carried out by the
government. While the cost and benefits may relate to goods and services that have a simple
and transparent measure in a convenient unit (e.g. money), this is frequently not so, especially
in the social case. In its essence cost-benefit analysis is extremely, indeed trivially, simple:
evaluate costs C and benefits B for the project under consideration and proceed with it if, and
only if, benefits match or exceed the costs.

Social Cost Benefits Analysis means to analyse the social cost and total social benefits if we
accept any project. We all know that for completing the big project, we need big investment.
In social cost benefit analysis (SCBA), we see whether return or benefits on this investment
are more than its cost from point of view of society in which we are living. In public
investment, we analyze and compare government expenditure with total benefits to society
through SCBA. It is also a good technique of financial evaluation of a project because we
reject those projects whose benefits to society are less than their total cost because all the
resources are drawn from the society.

The market prices, in the case of developing countries particularly, are substantially at
variance with their appropriate social prices. The social costs and benefits will be presented
in terms of the domestic currency equivalent of the foreign exchange value, also referred to as
unit of account or numeral.

Rationale for SCBA

a) Market imperfection: The following factors are to be considered to understand the

market imperfection.

 Rationing factor: It means some of raw material prices are controlled by Government
and hence, project cost may increase but its social benefits will go to poor community.
 Regulation for providing minimum wage factor: It also affects social cost and benefits
of any project.
 Foreign Exchange Regulations factor: Sometime, projects involve foreign currency
transactions. Hence, we should analyze this point also.

b) Externalities: Externalities are non-cash or benefits which an organization suffer or get if

it starts the project. For example, if government lays road near your project plant, you can get
this facility without any payment. On the other side, if any other organization is polluting and
spreading diseases, it will create adverse impact due to absence of employee because they go
to hospitals.

c) Tax and Subsidies: Tax is levied on the earning of the project and it will reduce the
overall benefits. On the other hand, if government gives us subsidy for operating any project,
it will count for our cost benefit analysis.

Arriving Net Benefit of Project to Society

With United Nations Development Organization (UNIDO) approach, we can evaluate net
benefit from any project. Formula is given below:
Factors which Complicate SCBA

There are a variety of factors which make SCBA complicate:

 Benefits and costs may accrue to different sets of people. If this is so we need some
way to aggregate and compare different benefits and costs across people.
 Benefits and costs may occur at different points in time. In this case we need to
compare the value of outcomes at different points in time.
 Benefits and costs may relate to different types of goods and it may be difficult to
compare their relative values. This usually occurs when one of the goods does not
have an obvious and agreed upon price. For example, we may be spending standard
capital goods today in order to obtain environmental benefits tomorrow.
 Benefits and costs may be uncertain.
 Benefits and costs may be difficult to calculate and, as a result, there may be widely
differing views about their sizes. One might think this could be considered under
uncertainty, however the two points are rather different: two people agreeing that an
outcome follows some probability distribution are different from them arguing about
its mean and variance.

Importance of Social Cost-Benefit Analysis

The elements of costs and benefits are identified both from the point of view of undertaking,
implementation and managing the project, and from the point of view of the society. The
Project Appraisal Division of the Planning Commission is the main agency that scrutinizes
and evaluates all projects after the Public Investment Board has carried out the scrutiny from
the financial angle. Together, these two agencies have the responsibility for the planned and
the coordinated development of the country.

Maximization of social welfare is the national objective. Public Enterprises constitute an

instrument for achieving this objective and, as such, the selection of their projects requires to
be synchronized with the national plan. This synchronization process has two stages.
  First, the sectoral allocation of the resources has to be effected on the basis of
approved sectoral plans.
 Then, within the sectoral plans, appropriate projects have to be identified for funding.

Projects are the building blocks of the sectoral investment plans. Social Cost Benefit Analysis
is an important method of synchronization of the project’s aims with national objectives.

Government investments aim at:

 Growth
 Equitable distribution of gains
 Self-reliance

Social cost benefit analysis enables the qualification of the gains of these objectives and
aggregates them into a common numeraire or composite index for determining the
acceptability of projects and for assigning priority to any given project in relation to
acceptable projects.

SCBA Considerations for Various Categories of Investments/Projects

The investment could be in any of three categories:

 Capital intensive industrial investment;

 Infrastructural investment;
 Agriculture, rural development and related projects.

a) Capital Intensive Industrial Projects

The prime consideration in appraising industrial projects in this category is efficiency. The
steps involved are:

 Eliminate all transfer cost items, i.e., taxes and duties, including indirect taxes;
 Value all tradable inputs and outputs at border prices or international resource costs.
This is based on the logic that domestic prices are distorted.
 All non-tradable items, such as power, transport, etc., are to be evaluated on the basis
of marginal cost. The aim is to eliminate the distortion between the market tariffs and
the marginal costs.
 Foreign exchange involved in the inputs or outputs are valued at specific premia and
there should also be a sensitivity analysis carried out to assess the impact of variations
in the premium on foreign exchange.
 The average social return on capital or the Social Discount rate (SDR) to be used for
evaluation is 12 per cent and the costs and the benefits are to be discounted at this
rate.

b) Infrastructural Investment

In the case of infrastructure projects, the classical SCBA is adopted with due emphasis on
externalities. The gains to the users of the facilities and the gains to the project are assessed.
In enumerating the gains to the users, the attempt is made to understand the gains to society
accruing from the project on a multiplier basis.

c) Agriculture, Rural Development and Related Projects

As distinct from the ‘growth’ projects referred to above, these constitute the ‘equity’ projects.
Though the economic factor is the main consideration in the choice of agricultural projects,
importance is also given to the identification of external or consequential benefits accruing
from the project to the consumers and other sections of society. A functional distribution of
gains is attempted, classifying by occupational and income categories. Priorities for projects
with gains to the lowest income strata can thus be determined.

The Social Rate of Discount

The choice of the social rate of discount is a matter of debate. A high rate of discount will
favour projects with immediate net benefits, the emphasis being on present consumption. On
the other hand, a low rate of discount will favour present saving and future consumption.
There is a subjective element in the choice of the discount rate.

Conclusion

SCBA has equal validity for large private sector projects too. It should be a discipline that
applies to all major investments, in the public or the private sector, to make the system of
national planning systematic and effective. There is the need to create the awareness in the
private sector of the logical necessity for using SCBA in project appraisal.