UNIVERSITY OF THE WITWATERSRAND SCHOOL OF CIVIL AND ENVIRONMENTAL ENGINEERING CIVN2007: ECONOMICS AND MANAGEMENT PROJECT DEFINITION Aspects

of Project Appraisal If you are approached to make a full appraisal of an engineering project, there will be many dimensions to your study, as listed below: Economic: cost and benefit to broader society. This is the focus of the first part of this course. We need to have an understanding of how projects fit into the broader economic framework of a country or region so that we can make informed decisions. In many cases, we are asked to appraise projects for public and private sector clients so that they can make wise decisions, develop budget proposals, and make goos investments. Social: income distribution; job creation; health; re-settlement, etc. The technical and other decisions and proposals we make will always have a social impact, whether we intend this or not. If we have ways of measuring these consequences, we are better able to turn this impact to the greater benefit of the project. Institutional: management; organizational; legal; staffing during construction & operation. This is the focus of the second part of the course (term 4). Financial: how much it costs; sources of funds; cash-flow; return on investment; profits. This section of the course introduces us to some of these techniques which we look at in more detail in term 4. Commercial: procurement of goods and services to build and operate project. We touch on this in term 4 and again in 4th year. Technical: design; direct environmental aspects; capital and operating costs. All your other courses contribute to this!

At the early stages, when a project is first contemplated, the client is planning to raise funds, but few resources have been expended on it yet, the economic appraisal will be the focus and possibly the only part of the appraisal that is carried out. If this evaluation is negative, no more money needs to be wasted on the other more detailed studies. Project Definition Webs of economically interlinked activities and types of infrastructure make it difficult to define the scope of a project and therefore difficult to appraise and manage. We need to be able to distinguish precisely what we are appraising, especially when we are working with non-engineers who may have quite blurred ideas of what the project includes and excludes.

Defining these limits is also important, in that if we are evaluating a complex combination of sub-projects, some of these may not be viable and could result in the overall proposal getting a negative rating, even though other elements of the proposal are extremely viable on their own. The following definitions help us to gain a working understanding: the smallest operational element prepared and implemented as a separate entity in a national plan. (Gittinger, 1982:5) a project is the minimum investment which is economically and technically feasible. (Adler, 1987:5) Adler expands on this with an example of a 2km stretch of rail between two towns being of no use to anyone, while a 2km upgrade of a larger existing road network can be useful. The smaller the scope, the easier it is to evaluate, plan, finance and manage. Several projects can be linked in a programme approach if they are economically linked. The Role of the Project in a Sectoral Programme Almost all infrastructure projects need to mesh in with a broader national framework for that particular type of service, and in many cases also relate to other types. For example, a water supply project may extend as far as a neighbouring province or country (eg the Lesotho Highlands Water project), and also has to be related to the sanitation systems that this water system supplies. In more developed countries, extensive surveys exist for all forms of infrastructure that assess present usage and predict future trends. In less developed areas, the project team may have to piece together this kind of information, but within a national or regional strategy and the existing infrastructural frameworks. These surveys would show: overall needs for each type of infrastructure priorities for each type

In South Africa, there is fairly comprehensive information, especially at national and provincial levels, which is translated into strategic plans for each of the government Departments that oversee the provision of infrastructure. The annual Budget Speech adapts this strategy at national level from year to year in the light of political, economic and social change. This is reflected in changing allocations to each Department. In South Africa, much of the infrastructure provision and maintenance is devolved to Local Government level, steered by Integrated Development Plans (IDPs). Forecasting infrastructure needs Extrapolating from past trends, we would take the following steps: 1. Location and volume of future use and population growth. We need to look at specific location, not just overall macro-economic growth, especially for fixed infrastructure, also at rate of growth slow growing demand needs more accurate forecasts

2. Translate to type of infrastructure (eg amount of traffic, for transportation). Here we look at origin and destination of the transportation users and also look at trends, eg shift from rail to road, changes in relative costs (eg fuel type). 3. Lastly we look at most efficient modes of distribution (eg road, rail, canal). In principle, the transport should be allocated to mode that carries lowest cost, but we need to look at both the financial and economic costs, costs and values of consumers (willingness to pay), legislated levies and subsidies, existing patterns and preferences tendency for individuals and firms to carry on existing methods because they are geared for one mode rather than another. Community Participation In less developed countries, community participation plays an important role in determining the kind and level of infrastructure that local people have as priorities. In highly industrialised countries, most of the basic infrastructure is already in place, so it is viable to extrapolate trends from how these are being used. Various methods have been developed for identifying user needs and preferences: Participatory. These methods are time-consuming and only really effective with small and homogeneous groups. The researchers will spend weeks or months with the community, interviewing inhabitants, holding workshops and mapping out their needs and desires, living with the problems and talking through a range of options. Rapid appraisal. In this approach, the researchers do desktop studies and brief visits, followed by questionnaires or short workshops to solicit local opinion. (quicker, but can be quite superficial and biased) Information meetings and discussion forums. This is the method mainly used in the Integrated Development processes of South African local government. It is often criticised as rubber stamping the decisions made by politicians, funding agency personnel, civil servants or professional consultants.

Evaluating Competing Projects

The aims of private and public sector clients tend to be quite different, so our approach to project appraisal may be somewhat different. In general, the private sector needs to make a profit that is at least as rewarding as another investment at a similar level of risk. There are several approaches that we can use, depending on what kind of information is available and what the appraisal will be used for. Private sector. Internal rate of return (IRR) Present worth (PW) Future worth (FW) Payback period (PP) Capitalized equivalent (CE) We will be focusing on the first two, as they are the most commonly used for construction projects: all the methods will give the same result in terms of choosing or ranking proposals.

Public sector projects seldom have profit as an objective, and may not even have an expectation of cost recovery they are there to provide a service to the public, paid for out of public funds. Where service charges are levied, these are more often to curb wasteful practices rather than to gain income. For this reason the benefit-cost method is often used. We may use some of the methods discussed under private sector appraisal to confirm our evaluation and to give a clear picture of how we arrived

at the figures, but there is likely to be more of the non-numerical evaluation in our decisionmaking. Benefit-cost analysis a decision-making tool that is used to systematically develop useful information about the desirable and undesirable effects of public projects. (Park, 2007:833) Typical aims: maximize benefits within a budget: the overall maximum cost of the project is defined, and we try to get the best value for the money in terms of the objectives, needs and wants expressed by all the beneficiaries of the project. maximize net benefits when costs and benefits vary: the budget may not be defined, so we have to assure all the role-players that they are getting value for money, because money spent on the project might have been spent for something else. minimize costs to achieve defined benefits: again, the cost limit may not be set, but any savings that we can achieve allows more for other projects. In all of these scenarios, we need to present a clear picture of what is being gained and at what cost, as any public body will have a large number of objectives that they want to address. Project appraisal must be presented in a format that can stand up to public scrutiny and accountability because we will be using public funds. All assumptions need to be explicitly stated, so that if the outcomes are not as expected, we are protected through being able to show that we gave the best advice with the information available at the time. Framework of benefit-cost analysis The following steps are useful to structure the analysis: 1. Identify all benefits expected from the project 2. Quantify benefits in money terms as far as possible 3. Identify and quantify costs 4. Decide on an interest rate, often specified by the body commissioning the study as it is a measure of the scarcity of resources relative to other projects 5. Bring all costs and benefits to a single point in time. 6. If benefits outweigh costs, the project can be accepted The problem of attaching monetary value to benefits, especially in poor communities, can be mitigated through the use of proxy values, as we have explored in the assignment. Sometimes even these are not realistic, so we can outline verbally a range of benefits that would attach to the project and pass this side of the evaluation back to the client body to make the final decision.

Attaching value to benefits One way of evaluating benefits of project s for poorer communities is to look at the cost of not doing the project, eg with a water purification plant we can attach a cost to: health services from drinking impure water; death through waterborne disease; loss of tourism; and lowered commercial land values near a contaminated water supply (river). We can also look at the cost of alternatives: Imported drinking water (tankers) Bottled water (!!) Water restrictions to already serviced areas to cross-subsidize the project. Time value of money What is interest? When money is borrowed, the interest paid is the charge to the borrower for the use of the lenders property (Park, 2007:54) Think about the opportunity cost for the lender: she could have used the money to buy a new car and save on fuel bills; bought a painting that would have increased in value while giving pleasure; gone on a world cruise. By lending out the money, she is holding over her present utility for the future. Interest We generally value having or using something in the present higher than in the future, so if we allow someone else to have the immediate utility of that money, we will want more back in the future, to pay us for the present sacrifice. The rate of interest needs to be higher than inflation, otherwise when we get the money back we would not be able to buy the equivalent things that we would at the time of investing. Time value of money is the concept that R1 today is worth more to me than R1 in the future because the money that I receive today can earn interest. Simple interest If you invest R120 at 10% interest per year, at the end of 12 months, you will have: R120 + (R120x10%) = R132 Generalised to: F = P + iP where F is final amount at the end of the period; P is the principal (amount invested); i is the interest rate. With simple interest, you dont get interest on the interest, so for several interest periods (N): F = P(1+ iN)

Compound interest With compound interest, the interest at the end of each period is included with the principal to calculate the interest for the next period. If you invest R120 at 10% interest per year, with a 1 month compounding period, at the end of 12 months, you will have: Month1: R120 + (R120 x 10%)/12 = R 121 (interest divided by 12 for 1/12 of the year) Month 2: R121 + (R121 x 10%)/12 = R122.01 Month 12: R131.47 + (R131.47 x 10%)/12 = R132.57 F = P (1 + i)N Over one year, this looks like no big deal, but the longer the investment period, the bigger the difference. In 1626, the Dutch bought Manhattan Island for $24. If they had rather invested the money at 8% interest, compounding annually, P = $24; i = 8%; N = 381 years, so: F = $24(1+0.08)381 = $130 215 319 909 015 If $24 were invested at 8% simple interest for 381 years it would only generate F = $24[1+(0.08x381)] = $755.52 (Park 2007)

This example highlights that both the time-frame and the method of raising funds can play a large part in the evaluation of projects. The time that money is expended or benefits are received (in money or other value) is also important, so we show a time-line and bring the values to one common date.

Social discount rates As you can appreciate from these examples, we need to decide on an interest rate to allow a comparison between projects with different time-lines for costs and benefits. The rate of interest for public projects is often a political decision that reflects priorities in spending, eg low interest rate on water and sanitation, high on airport projects will tend to be pro-poor; low interest rates on solar power and high for coal generated electricity supports a green agenda.