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p. 65 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 23 : Financial Returns to Project Participants : An Illustration

1. The design and sustainability of a project must take into account the level of incentive for undertaking and maintaining a project investment. The financial incentive takes the form of the increased income the investment generates for project participants. This can be calculated as the difference between the level of income in the without project case and the level of income in the with project case. Where the main project participant is a corporation, either public or private, a financial statement in real financial prices can be drawn up showing the net income generated by the project investment after allowing for loan inflows and loan payments, and taxation of profit.

2. The following illustration relates to a water supply project in India, the Channapatna/Ramanagaran water supply project, that would be implemented through a corporate entity. The illustration presents a financial statement for the project from the point of view of the water authority. The financial and economic analysis for this project has been based on various assumptions about project costs, the level and affordability of user charges for water, projected demand for water, and the use of unaccounted-for-water (UFW). All these factors are interrelated and relate to the basic project economics. The level of demand, the use of UFW, and the economic benefits derived from the project supplies, will depend upon user charges. The project has been scaled to meet the projected demand levels, which also determine the financial and economic returns to the project.

3. The basic features of the project statement are

• The initial investment is spread over the four years from 1996 to 1999.
• The project assets are operated for 31 years, after which they have no residual value, with a small replacement investment in the fifteenth year of operation.
• The operation and maintenance (O&M) costs increase gradually with supply.
• The average price of water rises over the whole 35 year project period from Rs1.72 per m3 to Rs6.18 in real terms.
• Water sales on the basis of the project supplies increase over the first 12 years of the project, then remain at a constant level.
• Twenty percent of the UFW is assumed to be used without generating any direct revenue.

4. The project statement drawn up at financial prices includes

• project net resource benefits (revenues minus investment and O&M costs);
• loan inflows;
• loan principal and interest payments; and
• profits tax payments.

These are included in Table 1.

5. The financing arrangements allow for India to take a loan to cover 80 percent of the initial investment costs in each implementation year. However, consistent with Government policy, this is re-lent to the water authority at a nominal interest rate of 12 percent. The loan enjoys a grace period of five years and is then repayable over a 20-year period. Table 2 shows the loan schedule, with the loan payments divided between principal and interest. The water authority makes no payments of interest or principal on the government grant covering 20 percent of the initial investment cost.

Table 2. Loan Schedule (Rs millions)

6. Allowing for annual O&M costs, depreciation (deflated by anticipated inflation of 3.2 percent per annum), and interest payments, the water authority has an annual loss for most of the first eight years of the project period (see Table 3). Thereafter, the accumulated profit remains negative through the year 2009. The water authority would become liable for profit tax at the rate of 46 percent of gross profit from year 2010 onward. The water authority makes no payments of dividends.

Table 3. Profit Tax (Rs millions)

7. Table 1 shows that the water authority, at projected levels of sales, will earn a return to equity of 4.4 percent. The sales allow recovery of all investment and O&M costs, will meet financing obligations, and will still yield a small return to the authority. It will need no financial subsidy.

8. How should this return to equity be assessed? The key question is whether it provides sufficient incentive to the owner to undertake and maintain the investment. Without sufficient incentive, the economic benefits of the project will not be realized. This assessment requires that the return to equity be compared with the cost of investment funds, that is, the return that is required to induce an increase in the availability of savings or foreign investment inflows, or the return that is necessary to induce investment in this project, rather than an alternative project, or a combination of the two.

9. A return to equity of 4.4 percent is insufficient to induce an inflow of foreign investment funds. Private foreign investors in many countries are looking for returns of 16 to 20 percent in real financial prices. This range includes an allowance for economic and political risks. Nevertheless, it is far higher than is generated by the water supply project. Private domestic investors also are likely to have alternative investment opportunities that yield returns greater than 4.4 percent in real terms. Where interest rates are managed, this may not be in financial assets, but may be in other productive investments or in property. Private investors will be excluded by the level of the return to equity.

10. Government investment also may be excluded. This depends again upon the cost of investment funds. Recent estimates of the opportunity cost of investment funds for three member countries, combining estimates of returns to savers and investors, and allowing for the elasticity of the demand and supply of investment funds at different real interest rate levels, suggests that the cost of investment in real financial prices is between 10 and 12 percent (see Appendix 20 for an example). This opportunity cost may also be used by government in selecting project investments in financial terms. However, governments will also take into account the economic benefits from the increased supply of treated water. These economic benefits may justify implementing the project even though the financial return is less than could be obtained elsewhere in alternative uses of the investment funds.

11. Finally, is the return to equity sufficient to justify operating the water supply project on a corporate basis? There is a risk in establishing a corporate authority to operate a project at this level of return to equity. The extent of this risk can be investigated using sensitivity and risk analysis. In this case, the return to equity is very low, and the water authority might require a financial subsidy during implementation and operation if project cost estimates are exceeded or if the projected levels of demand do not materialize. However, it should also be noted that the return to equity is also affected by the terms of relending of external finance. The external finance, borrowed at a nominal rate of 6.9 percent, is re-lent to the water authority at a nominal rate of 12 percent, or a real rate of 8.6 percent. Bearing in mind the effect on the accumulated interest during the grace period as well as the rate itself, if the terms of relending are set equal to the terms of lending, at a nominal 6.9 percent, the return to equity for the water authority improves from 2.9 to 11.9 percent. Therefore, to avoid future reliance on government funds and the consequent risk to water supply operations, the rate of return is sufficient for the water authority to be set up on a corporate basis, but at a lower re-lending rate.

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