Generally, in a project analysis situation, most analyses focus on the cash inflows and outflows of a project. Critical expenses and incomes are usually compared to determine whether a project should be undertaken or not. But expenses and revenues in most financial analyses are mainly the consideration of a private investor.
The
implication of financial analysis is that it provides a micro view of a project
and concentrates attention on things like accounting profits.
Economic
analysis on the other hand considers projects from a macro point of view. The
type of questions asked in an economic analysis are:
1.
Will the project under consideration lead to the
general well being of the community, the state and the nation?
2.
Will the project generate employment at various levels
in the macro environment?
3.
Will the project lead to economic growth?
4.
What are the linkages that the project has, i.e.,
forward or backward linkages?
5.
Will the project generate more technical knowledge?
The questions
that we have asked are not exhaustive but only go to demonstrate the type of
questions that economic analyses seek to answer.
Financial Analysis and Economic Analysis - a Comparison
In general
theory, a financial analysis tries to solve resource allocation problems. It
tries to use information from projects to determine whether projects should
come on stream or not. Economic analysis also tries to solve resource
allocation problems in an economy. In economic theory, resources are very
scarce and it is part of any good analysis to allocate resources between
competing projects. For example, resource allocation problems can arise if a
community is trying to decide whether to build a school or a hospital with
limited scare resources.
Financial
analysis equally tries to allocate resources but from a micro view point. So,
both financial and economic analyses solve resource allocation problems.
Financial
analysis tries to concern itself with issues of both benefits and costs arising
from a project. In the financial analysis, the concern of the analysis is to
evaluate the stream of costs attached to a project and deduct same from the
stream of benefits.
If the stream
of benefits is greater than the stream of costs, then project in question has a
positive value and should be accepted, all things being equal. However, if the
stream of costs is greater than the stream of benefits, then the project in
question has a negative value and should not be accepted, all things being
equal.
Economic
analysis also concerns itself with costs and benefits arising from a project.
If the stream of benefits is greater than the stream of costs, then the project
in question has a positive value and should be accepted.
However, if
the stream of costs is greater than the stream of benefits, then the project in
question has a negative value and should not be accepted, all things being
equal. So we could say that financial analysis and economic analysis both
concern themselves with costs and benefits arising from a project. In the end,
they provide answers to the question of whether a project should be acceptable
or not. In evaluating projects, both use discounting and compounding techniques
to arrive at their answers.
However,
there exist conceptual differences between financial analysis and economic
analysis. While financial analysis has a primary objective of establishing the
viability and acceptability of a project from a financial view point, paying no
attention to society, economic analysis has the objective of establishing the
fact that a project is acceptable or not to the society as a whole. So while
financial analysis has a micro objective, economic analysis has a macro
objective.
Finally, in
reaching a decision as to whether or not to accept a project, financial
analysis and economic analysis both try to establish a relationship between
costs and benefits.
For example
in financial analysis, costs and benefits arising from a project are usually
defined in monetary variables such as profits. But economic analysis goes
really beyond the vague definitions of profit. In Economic analysis, costs are
defined in terms of opportunity costs or foregone costs to the society as a
whole.
The Nature of Economic Analysis
In the
literature, there exist three discounted measures of project worth which we
will now discuss:
The Net Present Worth
The net
present worth is the difference between the present worth of benefits and the
present worth of costs. We can write thus:
Generally,
according to the net present worth theory, a project is acceptable if the net
present worth is positive. If the net present worth is negative, the project
will be rejected.
Benefit-Cost Ratio
If you divide
the present worth of benefits of a project by the present worth of its costs,
then you have what is known as the benefit-cost ratio. We can write thus:
Generally, a
project is acceptable if the benefit-cost ratio is greater than 1 (one).
If the
benefit-cost ratio is exactly 1 (one), that project is a break-even project.
The Internal Rate of Return (IRR)
The internal
rate of return is a discount rate where the present worth of benefits is equal
to the present worth of costs.
Under the
internal rate of return evaluation method, a project will be acceptable if its
internal rate of return is higher than the firm’s required rate of return.
The starting
point of economic analysis is the financial analysis of a project which should
be properly concluded before embarking on an economic analysis. Some
adjustments will be made to the calculations to arrive at economic data.
First, it may
be necessary to include or exclude some costs and benefits which may have been
included or excluded from the financial analysis.
Secondly,
some project inputs and outputs may have to be revalued if their shadow prices
differ significantly from their market prices.
Adjustments to Financial Analyses
We have stated that the
starting point of an economic analysis is a financial analysis, so if we have
financial data on financial analysis, we need to make some adjustments to the
financial analysis to arrive at economic analysis data. We shall now consider
some of the adjustments:
Transfer Payments
Transfer payments
represent transfer of resources from one section of society to another. They do
not make any claim on the country’s resources and as such, their impact should
be clearly distinguished and analysed in the economic analysis.
One of the first
transfer payments we shall consider is interest. Interest is a reward for
capital. For example, if a project is funded through a bank loan, the interest
component is included in the profit and loss statement.
The interest charges in
the profit and loss statement represent transfer payments from a project to the
provider of funds. What the project lost (interest) has become a gain to the
provider of funds.
In effect, both figures
are equal and cancel out without any net increase to society of funds.
Therefore in economic analysis, interest charges are excluded since they only
represent transfer payments.
The second transfer
payment we shall consider is tax. When a project is profitable it is expected
to pay taxes to the government at the ruling rate. In computing the profit of a
project taxes are deducted to arrive at net profit. Taxes therefore appear as
outgoing cash flows. Taxes represent transfer payments from a project to
government.
In the economic
analysis of a project, taxes are excluded because from the point of view of the
society, they are only a transfer of resources from one section of the economy
to another.
The third transfer
payment is subsidies. In a traditional private sectors setting, it would be
unheard of to talk of subsidies. But in economic analysis, subsidies appear as
important data. Most public sector projects enjoy government subsidies to
enable the poor gain access to certain services which ordinarily they cannot
afford without government assistance. Subsidies represent opportunity costs to
a nation as a whole. Therefore in estimating the true cost of a project in an
economic analysis, subsidies should be included.
Linkage Effects of a Project
Consider a simple case
where a university is newly located in an environment. Many investments will
begin to spring up. New housing developments will begin to spring up; canteens
will begin to spring up; hair dressing salons, etc. will begin to spring up to
cater for the needs of the new university community. Such constitute the
linkage effects of a project.
Generally, there are
two types of linkage effects which we shall briefly discuss:
Forward Linkage Effects
Forward linkage is the
stimulus given to industries that use the products of a project. A case in
point is a flour manufacturing project. Flour has so many uses. If a flour mill
is located in an environment, it will lead to the establishment of such projects
as bakeries which will use the flour.
Backward Linkage Effects
Backward linkage
demonstrates the stimulus to industries that supply the inputs to a project.
For example, the establishment of a flour mill in an environment will lead to
demand for wheat which is a major input for flour mill. The flour mill will
lead to investment in wheat cultivation.
Also, the establishment
of a car assembly plant will lead to the establishment of tyre manufacturing
plants that need to supply tyres to the car assembly plant.
Example of an
Economic Analysis
In the year 2006, the
World Bank was considering the desirability or otherwise of assisting Nigeria
set up an ethanol plant covering thousands of hectares in the Niger Delta area.
Under the scheme, young
farmers will be allocated hectares of land for subsidized cassava cultivation.
Such inputs like fertilizers will be heavily subsidized while technical advice
will be provided by the World Bank/ Nigerian agricultural experts.
CONCLUSION
Introduction to economic analysis has provided us with the tools to conduct economic analyses, with financial analyses as a starting point.
Financial analysis is
the private sector’s view of a project without considering a project’s impact
on the society. Economic analysis is a macro view of a project, taking into
consideration the project’s impact on society.
ASSIGNMENT QUESTIONS
What do you see as the
basic differences between the financial analysis of a project and the economic
analysis of a project?
REFERENCES AND FURTHER READINGS
Leon Ikpe (1999).
Project Analysis and Evaluation. Lagos: Impressed Publishers.
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