Economic Analysis Of Investment Operations

By M. Isi Eromosele

The main purpose of project economic analysis is to help design and select projects that contribute to the welfare of a country.

Economic analysis is most useful when used early in the project cycle, to catch bad projects and bad project components. If used at the end of the project cycle, economic analysis can only help in the decision of whether or not to proceed with a project.

When used solely to calculate a single summary measure, such as the project’s net present value (NPV) or economic rate of return (ERR), economic analysis serves only a very limited purpose.

The Economic Setting

A project cannot be divorced from the context in which it takes place. The link between the project and the sector and the country strategy need to be established early in the presentation of the project. The key role of the policy and institutional framework also needs to be discussed. Research indicates that projects do better in environments with low distortions than in highly distorted environments.

One of the first questions analysts should ask is whether the sector and macro preconditions are satisfactory for the project. In particular, they should inquire whether there are key distortions that should be removed prior to project implementation to ensure project effectiveness.

The relationship of the project to the broader development objectives of the sector and of the country is an integral part of the economic justification for the project, and analysts should always ascertain that the project fits with the broader country and sector strategies.

Rationale For Public Sector Involvement

Worldwide, the private sector in increasingly providing goods and services that a few decades ago were deemed to be properly in the domain of the public sector. Two main reasons account for this development.

First, an inconclusive, yet growing, body of evidence indicates that the public is less efficient than the private sector when engaged in market-oriented activities. Second, technological changes are making it possible to have competition in markets that traditionally had been considered natural public service monopolies.

The tools of economic analysis can help analysts (a) judge whether the project would be financially viable if done by the private sector; (b) assess the magnitudes of externalities associated with the project; (c) estimate the impact of policy distortions and market failures on the project’s economic and financial flows; and (d) identify the incidence of costs and benefits on various groups in society.

What Is The Objective Of The Project?

The first step in the economic analysis of a project is to define clearly the objective(s) that the project is trying to achieve. A clear definition of the objective is essential to reduce the number of alternatives considered, and to select the tools of analysis and the performance indicators. Is the project trying to achieve a narrow objective or is it trying to achieve a broader objective?

The appropriate tool of analysis also depends on the breadth of the objective. In short, a clear objective is essential to define the set of feasible alternatives for obtaining the desired result, and to select the tools to analyze the problem and the indicators of success.

Techniques For Assessment: Is The Project Worthwhile?

After taking into account all the costs and benefits of the project, the analyst needs to decide whether the project is worth undertaking. Costs and benefits should be quantified whenever reasonable estimates can be made.

For projects whose benefits are measurable in monetary terms, the appropriate yardstick for judging whether the project is acceptable is the project’s net present value.

To be acceptable on economic grounds, a Bank-financed project must meet two conditions: (a) the expected net present value of the project must not be negative, and (b) the expected net present value of the project must be higher than or equal to the expected net present value of mutually acceptable project alternatives.

The Process Of Economic Analysis

After identifying with- and without-project situations, selecting the best of the alternatives considered and dropping bad project components, the analyst prepares the financial analysis of the project.

This step, which examines the net benefits to the project implementing agency, conveys important information about incentives. It helps assess whether the project would be of interest to the private sector.

Once the financial analysis is complete, the analyst needs to adjust the flows and prices to reflect net benefits to society. The analyst must get the flows right by removing all subsidies and taxes from the adjusted financial flows and taking into account the project’s externalities, especially the environmental ones.

Transparency

It is important for the analysis to indicate the extent to which the success of the project depends on assumptions about macroeconomic, institutional, financial, behavioral, technical, and environmental variables, including assumptions about government implementation capacity, macroeconomic performance and availability of local cost financing.

The analysis should include a comparison of project assumptions with the relevant historical values, and spell out the rationale for any differences. When all these points are made clear, the economic analysis provides an easily understandable and transparent product that policymakers can confidently factor into decision making.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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