Economic Appraisal of Road Projects - Concepts, Definitions, Procedure

Dr. B. KANAGA DURAI Sr. Principal Scientist & Head

Road Development Planning and Management DivisionCentral Road Research Institute

New Delhi-20

HDM-4 Training Programme 12 th October 2011

Contents of the lecture

• Need for economic analysis of road projects

• Economic analysis – principles and factors

• Procedure for economic analysis

• Financial analysis

• Roads are the key component of the development process

• Development of roads absorb a high proportion of the national/state budget

• Increasing trend of motorized mode demands for well built roads

• Effective and efficient planning and management of road network

• Road development programmes conceived as project mode and are implemented

• The project is to be apprised and evaluated in-terms of it’s worthiness

Need for Economic Analysis of Road Projects

Project - concepts

Project Appraisal: It is the analysis and assessment of Projects - in terms of social, economic, financial, technical, environmental and institutional issues - related to a planned intervention.

Project Formulation: It includes the analysis to determine the economic formulation of the design features.

Project Evaluation: It is a process of analyzing number of alternatives with a value to evaluate their competitive advantage. It is final phase of the project appraisal cycle. Normally done using economic analysis.

“A project is the smallest operations element prepared and implemented as a separate entity in a national plan/ programme”

• Fundamental aspect of decision making in the real world to evaluate the economic worthiness of a project.

• To determine that which alternatives is the best in terms of profitability, cost savings, revenue enhancement, …..

Valuing the economic benefits:

Monetary & Non-monetary

Quantitative and Qualitative

Popularly known methods

Cost benefit analysis

Cost effectiveness analysis

Economic impact studies

Economic Analysis

Objectives of Economic Analysis

Economic justification of the proposed investment interventions

To measure the economic choice between mutually exclusive features of design

To measure the relative cost or tax responsibility of the users

To measure the relative justification of highway projects with other public funded projects

Principles of Economic Analysis The economic analysis is an objective and unbiased

It compares alternatives to seek out the best one

The ‘with and without (do minimum) project ’ concept is basic

Costs and benefits are measured in money terms

Total costs are compared with the direct benefits

Costs and benefits are forecasted over planning time horizon (Design period)

Economic prices are used

Planning discount rate is used

Common factors of equal magnitude in the alternative may be omitted

The analysis of the economy is independent of financing

Uncertainties to be acknowledged

Final decision may also be based on non-market factors

FACTORS OF ECONOMIC ANALYSIS FOR HIGHWAY PROJECTS

TRAFFIC FORECAST (Demand)

Highway Design (Supply)• Route location . Geometric parameters• Roadway surface . Length of the corridor • Traffic factors . other parameters

Market Factors Non-Market Factors

Highway Cost• Capital investment• Maintenance• Traffic operation• Administration

Road User Personal Preferences

• Comfort convenience• Impedances• Quality of ride

Method of Economic Analysis

MANAGEMENT DECISIONS

Public factors

Economic Input Factors

Analysis and synthesis

Overall programmePublic polices andPreferences

Road User Costs• VOCs• Accident costs• Travel time costs

Social-economic Effects

• Land and business economics

• Community consequences

Sources: Winfrey (1969)

• Selection of projects and establishing objectives

• Identify constraints and specify assumptions

• Define base case and identify alternatives

• Selection of policy variables and decision criteria e.g analysis period, discount rates, etc.

• Traffic projection and assignment

• Estimate Costs and benefits

• Compare costs and benefits

• Make recommendations

Steps in Economic Appraisal/Analysis

Definition of Road/Highway Projects

• In Highways - ‘road corridor’ are considered as project for development or improvement.

• The term ‘corridor’ in highways implies the group of parallel roads carrying the traffic between two specific points.

New Construction and Upgrading (improvement to higher standard)

Maintenance Projects -Reconstruction and Rehabilitation (To original standard)

Stage Construction (Planned improvement at fixed stages)

Projects in Highway Sector

Collection of Economic Base Data

The major factors of Economic Base:

• Population Distribution and its Characteristics

• Agricultural, Industrial and Infrastructure

• Domestic Income and Expenditure Pattern

• Area Development Activities and

• Regional Economic Development Programmes

Which is useful in understanding the study area as well as establishing various developmental aspects such as traffic growth rates, design features etc.

Traffic surveys and Forecasting

Need: Traffic affects geometric & pavement design, and thereby road user costs (demand side factor)

Traffic data collection and projections Using traffic census data, to establish traffic growth rates:

Normal Traffic Diverted Traffic Generated traffic

O-D surveys in some specific cases Speed and delay studies on the existing alignment.

Inventory and Preparing Engineering Design (Project) Alternatives (Supply side factor)

Why?

Based on the inventory data and the estimated traffic - various alternatives are visualized to meet the demand.

Some e.g:

Upgrading: paving an unsealed road, concrete pavement, full depth asphalt pavement, etc.

Widening: dual carriage way, lane addition, carriage way widening, etc.

Several combination of different design alternatives for maintenance of the existing pavement.

For each of the selected alternatives, cost estimates are worked out based on engineering design

Selection of Policy Variables

It depends on the parameters such as traffic condition, sub-soil characteristics, and other environment factors

This will help in calculating various costs incurred on the development & management of the project

Normally, the design life of highway varies from 10 to 50 yrs depending upon the type of pavement

Analysis Period: The most important amongst the policy variables is the Analysis Period which is depend on design life of the project

Contd…

Benefits and costs that occur in the future are less valuable than current benefits and costs

This is based on the theory of Law of Diminishing Marginal Utility of Consumption

It is assumed that the marginal consumption is inversely related to the level of per capita consumption.

If per capita aggregate consumption is expected to rise over time and the marginal utility of the consumption diminishes over the same time.

If the weights on increments to aggregate consumption diminish at a constant rate ‘i’, the stream of aggregate consumption is equivalent to project’s net present value.

The parameter ‘i’ is the rate of discount. It is known as Social Discount Rate or Rate of Interest.

DISCOUNT RATE: It is the rate at which future payments are reduced to a common time.

Selection of Policy Variables

Estimation of Cost

The cost of the road project consist of:

Initial Construction or Rehabilitation Cost Maintenance cost Vehicle and its operating costs

The project cost estimation is manly depend upon formulation of project alternatives and its’ design

• Economic cost are used for analysis not the financial (estimates) costs

Economic Costs Vs. Financial Costs

• Opportunity cost or shadow pricing • Willingness to pay• Availability of producer goods • Foreign exchange adjustments• Adjusted for taxes, duties and subsidies

The estimation of economic cost depends on:

In a perfect market system where the government interventions are less, the financial cost s of a project components are very near to the economic costs.

When the market is imperfect and where interventions are more (such as taxation, levy, etc.) the financial costs and economic cost are not same.

As an approximation, normally for road projects undertaken in India, a factor of 0.80 – 0.90 has been used to convert financial costs to economic costs.

Price Base - Inflation

Normally current prices are used in economic analysis of projects,

If, inflation factor is taken

Then,

both the costs and benefits should be inflated, so that their relative magnitude may be the same with (real value of money) or without (nominal value of money) the factor of inflation.

To add inflation i.e., convert base year, real rupee/dollar into data year, nominal rupee/dollar)

Rs base year = Rs data year X PI base year / PI data year

To remove inflation i.e., convert data year, nominal rupee/dollar into base year, real rupee/dollar)

Rs data year = Rs base year X PI data year / PI base year

PI = Price Index (Wholesale Price Index)

Treatment of Inflation

To add and remove the inflation effect

Measuring Economic Benefits

Vehicle operating cost savings

Road maintenance cost savings

Travel time saving

Reduced road accidents/pollution and

Economic development benefits

They are measured as:

It depend upon: • Aggregate consumption• Net output of the project • Foreign exchange earnings, if any

Estimated: Consumer surplus approach and producer surplus approach

Consumer surplus is defined as the amount of value perceived by a person or a society in excess of the cost of the goods purchased.

Consumer Surplus Approach

In road project it is Vehicle Operating Cost Savings (VOCS) between two different design/investment options

Producer Surplus Approach The benefits are calculated directly on the basis of the increase in the farm-gate prices of the agricultural produce in an area where the improvement of road facility has taken place. It is otherwise known as value added approach.

Methods of Economic Analysis

Net Present Value Method

B/C Ratio Method

Rate of Return Method

Performing Economic Analysis

Comparison of economic costs and benefits

In this method, the stream of costs/benefits associated with the project over an period of time is calculated and is discounted at a selected discount rate to give present value.

The NPV is expressed as:

Net Present Value (NPV) Method

nnn

i

CB

i

CB

i

CBCBNPV

)1(....

)1()1()(

22211

000

Where

NPV = Net Present Value in the year 0

B= Benefits, C=Costs, i = Discount Rate, N = Analysis Period

Year

(t)

Road User Costs Accident Costs Maintenance CostsBenefits

(Bt)

Col

[3+5+7]-

Col

[2+4+6]

Bt-Ct

Bt-Ct

(I+0.1)*tWith Impr.Without

Impr.With Impr.

Without

Impr.With Impr.

Without

Impr.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

0 - - - - - - - -100.0 - 100.0

1 105.5 126.5 1.1 3.1 3.5 2.5 22.0 22.0 +20.0

2 110.3 132.2 1.1 3.1 3.5 2.5 23.1 23.1 +19.1

3 115.8 138.9 1.2 3.5 3.5 2.5 24.4 24.4 +18.4

4 121.6 145.8 1.2 3.7 3.5 2.5 25.7 25.7 +17.6

5 127.6 153.0 1.3 3.8 3.5 2.5 26.9 26.9 +16.7

6 134.0 161.0 1.3 4.0 3.5 2.5 28.7 28.7 +16.2

7 140.7 168.9 1.4 4.2 3.5 2.5 30.0 30.0 +15.4

8 147.8 177.0 1.5 4.4 3.5 2.5 31.1 31.1 +14.5

9 155.1 186.2 1.6 4.7 3.5 2.5 33.2 33.2 +14.1

10 162.9 195.2 1.6 4.9 3.5 2.5 34.6 34.6 +13.4

+165.4

-100.0

=+65.4

The cost of improving an existing road, 25 km long, is Rs 4.00 lakh per km. Road user costs (with and without the improvements), accident costs (with and without the improvements) and maintenance costs (with and without the improvements) are given in Table for a 10-year period after the completion of the improvements.

Assuming a discount rate of 10 percent, find out whether the project is economically justifiable? Use the NPV method.

Worked out Example for NPV

Decision Rule for NPV

1. If NPV is positive, for the chosen discount rate, then the proposal acceptable

2. If the NPV is negative, for the chosen discount rate, then the proposal is unacceptable

3. If the NPV is zero, for the chosen discount rate, then the proposal is indifferent to the without project alternative

4. NPV/C (a cost-effectiveness approach) is used for ranking the alternatives for a set of projects/alternatives within a programme/ project

Benefit-Cost Ratio (B/C) Analysis

The costs and benefits over the analysis period are compared in order to ensure that the investment yields a satisfactory economic return

A simple procedure is to discount all costs and benefits to their present worth and calculate the ratio of the benefits to costs.

• Negative flows are considered costs, and • Positive flows are considered as benefits• If B/C ratio is more than 1, the project is worth

undertaking.

Year

(t)

Road User

Costs

Accident

Costs

Maintenance

Costs Benefits

(Bt)

[3+5+7]-

Costs

(Ct)

[2+4+6]

Bt-Ct

(1+0.12)tWith

Impr.

Withou

t Impr.

With

Impr

.

With

out

Impr

.

With

Impr.

Withou

t Impr.

(1) (2) (3) (4) (5) (6) (7) (8) (9)

1 101.5 160.7 2.5 3.6 10.0 7.5 57.8 51.6

2 105.6 168.2 2.6 3.7 10.0 7.5 61.2 48.8

3 110.2 176.3 2.7 3.8 10.0 7.5 64.7 48.1

4 116.2 185.2 2.8 3.9 10.0 7.5 67.6 43.0

5 122.3 190.0 2.9 4.0 10.0 7.5 66.3 37.6

6 128.4 199.5 2.9 4.0 10.0 7.5 69.7 35.3

7 135.6 210.0 3.0 4.1 10.0 7.5 73.0 33.0

8 143.2 219.5 3.1 4.2 10.0 7.5 74.9 30.3

9 149.1 228.2 3.2 4.3 10.0 7.5 77.7 28.0

10 154.6 240.1 3.2 4.3 10.0 7.5 84.1 27.1

Total: 382.8

An existing single lane road, 30 km long, is to be widened to two lanes. The cost of widening is Rs 10 lakh per km. The vehicle operating costs, accident costs and maintenance costs, with and without widening, for a 10 year period are presented in Table. The discount rate is 12 percent. Is the project worthwhile?

Cost of the Project = 30 x 10 lakh = Rs 300 lakh

Benefit/Cost ratio= 382.8/300 = 1.27 greater than 1

Hence, the project is economically justified.

All Figures in Rs lakh

Worked out Example for Benefit-Cost (B/C) Ratio Method

Decision Rule: If B/C ratio is more than 1, the project is worth undertaking.

Internal Rate of Return (IRR) Method

The IRR is nothing but the discount rate at which the present value of the costs and benefits are equal or in other words NVP is 0.

Equation :

Co = (B1 - C1) + (B2 - C2) + ............ (Bn - Cn)

(1+i)1 (1+i)2 (1+i)n

= ∑ (Bi - Ci)

i=1 to n (1+i)n

The solution to the above equation can be done by trial and error. However, the task of computing IRR is rendered very simple now-a-days due to the availability of this function as an in inbuilt one in all statistical software.

A

Present Value at Alternative Discount Rate

Discount Rate0

-

+

Present value of a project

20 %

Present Value and Discount Rate (IRR)

Decision Rule for IRR

• The higher the IRR, the better the project benefits.

• The project with an IRR higher than the market rate of interest should be chosen.

• It gives direct index to the degree of profitability of the proposals.

• It is useful to compare with and without project cased.

Internal Rate of Return (IRR) Method

Discount Rate0

-

+

Present value of a project (Rs. Million)

AB

Project Alternative B

20%-5%- 10%-

1

2

Conflict between Present Value and Discount Rate

Project Alternative A

Project Alternative ‘A’ yield higher IRR and a lower Present Value at Market Rate (5%) - vice versa Project Alternative ‘B’ ….

Which one we select ?

Financial Analysis of Road Projects

• The main objective of financial analysis is to find out the financial rate of return

• To examine the alternative sources of revenue generation

• It is to ascertain the existence of sustainable project returns, which shall successfully meet the expectations of its financial investors.

Objectives of Financial Analysis

Typical Financial Analysis Model

OUTPUT MODULE

CASH FLOW MODULE

CALCULATI ON MODULEI NPUT MODULE

Project CostBase CostEscallation

Toll ChargesToll Rates For Base Year

Traffic EstimateBase Year Traffic DataTraffic Growth Rates

Maintenance ExpencesRoutine MaintenancePeriodic Maintenance

Interest Cost

Toll Revenue

Operation ExpencesToll Collection

Admin.Expences

Maintenance ExpencesResources Mobilisation

Profit And Loss

TaxationBenefit Scheme 80I

IT Depreciation

Concession PeriodFIRR

1 Category wise toll rates are as per the prevailing rate.

2 Total number of days considered for collection of toll3 Toll rates are revised every year inflating with the rate of inflation

General Assumptions/Factors to be considered For Financial Analysis

Traffic Related:

1 All the basic costs are as per base prices and inflated to corresponding year with adopted inflation rate.

2 Construction time period 3 Project phasing (first year 30%, second year 30 % .....) 4 Cost for rising of fund is considered as5 Interest rate during construction is considered as 6 Compounding of interest during construction is7 Concession period is considered in years including construction period.8 Routine maintenance cost considered per annum (Rs millions)9 Toll plaza operation and maintenance cost (Incl. Env. & Insurance) (Rs millions)

10 Periodic maintenance is considered at every five years (Rs millions)

Construction Related:

Concession period including construction – say 20/25 years  Debt Equity Ratio considered for analysis - 70:30  Loan repayment period (Years) - 10 yrs  Grace period for loan/Moratorium (Years) – 2 yrs  Annual rate of depreciation  Tax benefits are as per-Section -------- of Income Tax Act  Corporate tax rate considered (Including surcharge and cess)  Minimum alternate tax rate considered for analysis  Rate of inflation considered as per actual WPI  Expected rate of return government contribution (If any)  Expected rate of return debt contribution  Expected rate of return equity contribution  

General Assumptions/Factors to be considered For Financial Analysis

Finance Related:

The output of the financial analysis gives the financial internal rate of return (FIRR) for concession period. The financial rate of return should be more than the commercial lending rate, then the project is viable.

Output of the financial analysis model

HDM-4 software provides easy solution for economic and financial analysis of highway project