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	Table of Contents
p. 57 of 74 BACK | NEXT I. Introduction II. Background III. The Economic Rationale of A Project IV. Macroeconomic and Sectoral Context V. An Integrated Approach To Economic Analysis VI. Identification and Quantification of Costs and Benefits VII. Valuation of Economic Costs and Benefits VIII. Large Projects, Linkages, and National Affordability IX. Least-Cost and Cost-Effective Analysis X. Investment Criteria: Economic Viability XI. Discount Rate XII. Uncertainty: Sensitivity and Risk Analysis XIII. Sustainability of Project Effects XIV. Distribution of Project Effects XV. Projects and Policies XVI. Appendices Appendix 1: Key Questions For The Economic Analysis of Projects Appendix 2: Project Economic Rationale: Market and Nonmarket Failures Appendix 3: The Project Framework Appendix 4: Identification and Measurement of Consumer Surplus Appendix 5: Treatment of Working Capital Appendix 6: Depletion Premium Appendix 7: The Use of Constant Prices In The Economic Analysis of Projects Appendix 8: General Methodology For Building Up Project Statements Appendix 9: Economic Evaluation of Project Output and Input Appendix 10: Economic Price of Traded Goods and Services Appendix 11: Valuation of Nontraded Outputs and Inputs Appendix 12: Shadow Wage Rate and The Shadow Water Rate Factor Appendix 13: The Economic Price of Land Appendix 14: Treatment of Resettlement Components of Projects Appendix 15: Calculating Economic Prices At The Domestic Market Price Or World Market Price Levels Appendix 16: Estimating The Shadow Exchange Rate Factor and The Standard (Or Average) Conversion Factor Appendix 17: Example of An Economic Rate of Return: An Irrigation Rehabilitation Project Appendix 18: Effect On Net Foreign Exchange and Budget Flows: An Example Appendix 19: Least-Cost Analysis and Choosing Between Alternatives Appendix 20: Estimating The Economic Opportunity Cost of Capital Appendix 21: The Treatment of Uncertainty In The Economic Analysis of Projects: Sensitivity and Risk Analysis Appendix 22: User Charges, Cost Recovery, and Demand Management: An Example For Piped Water Appendix 23: Financial Returns To Project Participants: An Illustration Appendix 24: Economic Evaluation of Environmental Impacts Appendix 25: Distribution of Project Effects Appendix 26: Impact On Poverty Reduction Appendix 27: Difference Between Economic and Financial Prices Appendix 28: Use of Economic Prices In Measuring Effective Protection Appendix 29: Exchange Rate Issues In Project Analysis XVII. Others

Guidelines for the Economic Analysis of Projects : XVI. Appendices

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Appendix 15 : Calculating Economic Prices at the Domestic Market Price or World Market Price Levels

1. The application of economic analysis to projects requires that all incremental outputs and inputs be valued at their opportunity cost. The resource effects of project outputs and inputs can be summarized into their traded good and nontraded goods components. For many items, the opportunity cost will be represented by their border price equivalent value (BPEV). For example, traded goods can be measured directly in terms of their trade effect; the opportunity cost of land and surplus labor may also be expressed in terms of traded goods. For other items, the opportunity cost will be estimated initially in terms of nontraded goods measured in domestic market prices. This breakdown of resource outputs and inputs into their traded and nontraded components must be done for all project capital, operating and working capital costs, and for all project benefits. Project capital costs are usually divided between foreign currency and local currency costs. Foreign currency costs refer to traded good inputs. A substantial proportion of local currency costs may also refer to traded goods, that is, goods produced and used domestically but having a trade effect on the economy in terms of imports or exports foregone. Local currency costs should be broken down between traded and nontraded good components.

2. In nearly all economies, domestic market price levels are higher than world market price levels. Where some project resource effects are estimated at world market prices and others are estimated at domestic market prices, there is a need to bring all resource effects to a common basis so that they can be aggregated into an estimate of project net benefits. To do this, it is necessary to define a unit of account, that is, to choose a price leveldomestic or world market price leveland to choose a currencynational or foreign currencyin which to express all project resource effects.

3. The simplest unit of account to adopt is to express all project effects at the domestic price level in national currency. This means converting all world market price values measured in national currency to the domestic price level using a shadow exchange rate factor (SERF). This procedure is most suitable where a large proportion of the project costs and especially the project benefits are nontraded goods. It also facilitates an analysis of the distribution of project effects. Alternatively, all project effects can be measured at the world price level in national currency. In the simplest form of analysis, this requires that a standard conversion factor (SCF) be used to revalue nontraded goods at their world market price level. This procedure is most suitable for small open economies where there is a very small proportion of nontraded inputs and outputs. Occasionally all project effects are measured at the world price level but in foreign currency. This option may seem suitable where most project effects are estimated in foreign currency anyway. However, it still requires that an SCF be applied to the value of nontraded goods to bring them to the world market price level.

4. The differences in the units of account can be illustrated through a simple example. A project will produce extra quantities of rice that will substitute for imported rice. At the official exchange rate of Rs10 to $1, the financial value of the rice output amounting to Rs400 can be broken down as in the first column of Table 2.

A shadow exchange rate of Rs12.5 to $1 has been estimated for the country concerned, implying a SERF of 1.25. When this SERF is applied to the traded goods component of the imported rice that will be substituted, and when all taxes on the imported rice are excluded, the economic value of the rice at the domestic price level in national currency is Rs425. Alternatively, an SCF of 0.8 can be applied to the nontraded component of the imported rice. With all taxes similarly excluded, this gives an economic value of the rice at the world price level in national currency of Rs340.

5. Both of these values, Rs425 and Rs340, represent the same thing: the economic value to the country of imported rice that will be substituted by the project. They are expressed in different units of account. The value of the rice at the domestic price level is 1.25 times the value of the rice at the world price level; put the other way, the value of rice at the world price level is 0.8 times the value of the rice at the domestic price level.

6. Where project effects are measured at the domestic price level, all their values will be greater than the same project effects measured at the world price level. They will all be greater by the same fixed ratio. This applies equally to outputs and to inputs. Where all project outputs and inputs are greater by a fixed ratio, the economic internal rate of return will be the same. Valuing project effects at the domestic price level in national currency will give a net present value that in absolute terms is greater than valuing all project effects at the world price level in national currency. However, the economic internal rates of return will be the same, and so the project decision will be the same whichever unit of account is being used.

7. The use of different units of account in the economic analysis of a project is illustrated by the following example for a railway project. Table 3 summarizes the economic effects of project inputs and outputs into their traded and nontraded goods components. The civil works element of capital costs involves both traded and nontraded goods components. All machinery and equipment is treated as traded goods wherever it is purchased. The opportunity cost of land is measured in traded goods while resettlement costs are treated as nontraded. For operating costs, the opportunity cost of surplus labor is estimated in terms of traded goods, while administrative expenses are treated as nontraded goods. There are two forms of project output: avoided road transport costs and extra net output achieved through releasing congestion on the system. The latter is estimated directly in traded goods. The opportunity cost of scarce labor and the avoided road transport costs, in principle, represent a mixture of traded and nontraded goods. However, they have not been separated. The opportunity costs have been estimated initially in domestic market prices and so they are treated as nontraded good components.

8. Table 3 presents the summary of project costs and benefits in two currencies, domestic currency or yuan, and foreign currency or US dollars. The official exchange rate is taken as Y8 to $1. However, a SERF of 1.08 has also been estimated implying that the domestic prices in which the nontraded components are estimated on average are 8 percent higher than the world price equivalents in which the traded good components are estimated. Tables 4a, b, and c illustrates three ways in which the project inputs and outputs can be brought to a common unit of account. Table 4a presents the project economic statement in national currency at the domestic price level, by applying the SERF to the value of all the traded goods components. Table 4b presents the project economic statement in national currency at the world price level, by applying the SCF to the nontraded goods components. Table 4c presents the project economic statement in foreign currency at the world price level, again by applying the SCF to the nontraded goods components.

9. The absolute value of the discounted net benefits differs between the first and the other two cases (see Table 5). Over a 26 year project period, and ignoring residual values, the net present value (NPV) using a 12 percent discount rate is 201 in national currency in the first case. In the second case, the NPV using the same discount rate is 186 in the same currency, and 23 in foreign currency. These last two cases differ only in the currency in which the project effects have been expressed. The first two cases differ because different price levels have been used to determine the unit of account. However, regardless of the unit of account used, the economic internal rate of return (EIRR) is the same in all three cases. If consistency is maintained in the use of a unit of account, it does not matter which is used for the basic project accept or reject decision.

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