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p. 62 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 20 : Estimating the Economic Opportunity Cost of Capital

1. The economic opportunity cost of capital (EOCK) is the weighted average of the demand and supply price of capital. The demand price for investible funds can be determined by the marginal productivity of capital and the supply price of savings by the social rate of time preference. The EOCK will therefore equal the opportunity cost of the marginal unit of investible funds to both investors and savers. While Bank practice is to use 12 percent as a hurdle rate, this does not necessarily reflect the cost of capital in a particular DMC. A different discount rate may be used in appraising projects provided that it is based on a country-specific estimation of the EOCK.

2. To ensure that a proposed project contributes positively to the countrys economic output, the project must generate a rate of return at least equal to the economic return foregone from deferred investments, plus the cost of any funds borrowed abroad to finance the project. In a closed economy, the additional demand for funds of a new project will be met either by displacing other projects from the capital market, or by inducing savers to supply additional savings. The financing required for the new project increases the demand for funds and the financial cost of funds. The higher rate of interest forces some of the existing demanders of funds to postpone their projects, thereby reducing the quantity demanded. At the same time, this rate induces some new savers to postpone their consumption and increase the supply of savings. The opportunity cost of funds used by the project is therefore the weighted average of the foregone marginal product of the displaced investment and the value of the foregone consumption. In principle, both of these values should be estimated in shadow prices in the appropriate numeraire.

3. The estimation of the EOCK is closely linked to the capital market, which allows the injection into, or sourcing of, funds from the rest of the economy. The weight of the impact of savings and investments on the EOCK may be expressed in terms of elasticities of demand and supply of funds with respect to changes in the financial cost or rate of return. Interest rates are basically determined by the willingness of both domestic residents and foreigners to save, as well as by the availability of investment opportunities. However, due to taxes, inflation, and risk premiums, the market interest rate will generally not reflect either savers time preference for consumption or the economic return generated by investments.

4. The estimation of the EOCK should allow for the impact of several groups of savers and investors by incorporating their respective elasticities, rates of return, and rates of time preference. Investors may be grouped into categories that generate different rates of return, such as corporations, small scale industries, agriculture, and housing; while savers may be divided into groups of low-income households, middle-income households, and high-income households. With foreign borrowing, the analysis essentially remains the same. The difference is that the interest rate of borrowing has to be adjusted upward because the additional borrowing from capital markets is usually available at a higher interest rate as compared to the interest charged on previous loans. The marginal cost that is relevant is given by the sum of the cost of borrowing of the additional unit and the extra financial burden on all other borrowings that are responsive to the market interest rate.

5. For an open economy that is not heavily indebted, the supply curve for investible funds will be elastic. In this case, capital will be a traded good for the country and EOCK will be the world supply price of capital. This will be the interest rate at which the country can borrow on the international capital market, typically LIBOR plus some premium specific to a country. This can be seen in Figure 1 where the relevant supply curve for capital is not the domestic supply curve SD but the perfectly elastic world supply curve SW. Although the project demand for capital shifts the after-tax demand curve from D to D(+P), this does not affect the cost of capital, which will remain at the world cost of capital, i_w.

6. Table 1 presents an estimate of the EOCK for the Philippines in 1993. The shares of each class of saver (Si/St) and investor (Ii/St) in total savings and investments is calculated from the gross savings and gross investments in the 1993 flow of funds summary matrix. Households include noncorporate business, while business includes financial intermediaries. The nominal interest rate (im) for domestic savers is the Treasury Bill rate for 1993. The average interest rate from new commitments from private creditors of 6.7 percent is used as the interest on foreign borrowing (if), adjusted for a 20 percent withholding tax imposed by the Philippines on all foreign loans. The tax rate for savers (ti) refers to withholding tax on savings. The foreign inflation rate is represented by the average annual weighted trade price deflator. The proportion of total borrowing (k) responsive to the interest on foreign borrowing is the 1990-1993 average ratio of Philippine debt from private creditors and nonguaranteed private debt to total debt outstanding.

Reference:

1. Flow of Funds Summary Matrix by Sector from Annual Reports of Bangko Sentral ng Pilipinas. Savers shares from gross savings. Investors shares from gross investment.
2. 1994 International Monetary Fund, International Financial Statistics. For households, business, and government, Treasury Bill rate is used. World Trade Tables (1994-1995): External Finance for Developing Countries, vol. 2, World Bank. For the foreign sector, interest rate is the average for new commitments from private creditors of 6.7% which is adjusted for withholding tax imposed on all loans contracted after 1 August 1986, pursuant to Chapter 3, section 25 of the National Internal Revenue Code.
3. Tax rate for savers (t_s) refer to withholding tax on savings. t_s for households is the average income rate for individual taxpayers, from a study of the National Tax Research Center from actual income returns filed for 1988.
4. World Debt Tables (1994-95). k=ratio of Philippine debt from private creditors and nonguaranteed private debt to total debt outstanding. k refers to average ratio from 1990-1993.
5. Nominal marginal cost of foreign borrowing = i_s*(1-t_s)*{1+k*(1/e_s)}.
6. Philippine Statistical Yearbook, 1994 for domestic inflation rate. 1995 ADB Key Indicators of Developing Asian and Pacific Countries for calculating average annual weighted trade price deflator (1981-1991) as foreign inflation rate.
7. Real marginal cost of foreign borrowing = ((n_s*(1+t_s)-p/(1+p))*(1+k*(1/e_s)).
8. Elasticities are estimates based on information from similar economies.
9. Earnings rate for households and government at lending rates. For business and foreign sectors, return on equity was computed from top 5000 corporations, but 15.7% was considered too low to attract investments. Thus, rates of 20% and 30% were assumed for business and foreign sectors, respectively. If rates of 25% and 35% are used, the EOCK will be 13.15%.
10. This estimate is made at real financial prices.

7. The elasticity of supply of savings (ei) and the elasticity of demand for investment (nj) are based on information from similar economies. The EOCK in the Philippines in 1993 is estimated at 11.5 percent. This estimate of the EOCK is in real financial prices. In principle, it should be converted to an equivalent value in real economic prices. In most cases, this conversion does not make much difference to the final numerical value. At the aggregate level, the EOCK of 11.5 percent can be interpreted as the ratio of net output derived from investment. This ratio can be adjusted by the ratio of the appropriate conversion factors.

                    Conversion Factor for output
Adjustment =  ^{_________________________________________}
                    Conversion Factor for investment

Whichever numeraire is used in the economic analysis, the ratio of these two conversion factors (CFs) will be the same. In general, the CF for output in general will be less than the CF for investment, because investment goods are typically less protected.. However, the adjustment is generally close to 1.0, and the difference in the rate at economic and financial prices is small.

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