Financial and Economic Basic Approaches in Benefit Estimation by Musgrave and Musgrave - Literature review Example

 Estimating benefits is the basic rationale for assessing the worthiness of proposed projects for funding. Sensitivity and risk analyses are some of the tools in the appraisal of benefits from a proposed project. We review what some of the practitioners’ manuals/guidelines and journals say on the topic to deepen our grasp on some of the appraisal and feasibility study techniques. Estimating benefits There are two basic approaches in benefit estimation: financial and economic. Financial benefits cover only monetary benefits while economic benefits cover both financial and non-financial. Economic benefits are also called social benefits. In general, one can assert that that there are no big issues with regard to monetary benefits estimation. However, estimation of economic benefits can be problematic. Estimation of economic benefits can be described as valuation. A distinct approach to valuation of projects and initiatives is one by Musgrave and Musgrave (1989, p. 137-143). In Musgrave and Musgrave’s approach, the value of projects and initiatives can be assessed based on gross benefits and costs. Based on gross benefits and costs, some of the fundamental measures that can be used to assess the value of a project or initiative can be the present value of net benefits, benefit-cost ratio, and internal rate of return. Other supplementary measures that can be used are measures such as the payback period. Lately, however, the World Bank has been reported to be shying away from these measures and have emphasized instead on the need to focus on objectives, particularly in defining and justifying objectives, and pointing out that a project or initiative is the least cost way of attaining the objectives (McElhinny 2010, p. 1). Nevertheless, economic benefit-cost analysis is still widely used by many countries of Europe (Odgaard et al. 2005, p. 18). Government agencies of the United States still use cost-benefit or benefit-cost analyses (Federal Emergency Management Agency 2006). Project proponents of the Asian Development Bank continue to use cost-benefit analysis to highlight the merit or lack of merit of a proposed project or activity (Infrastructure Professionals Enterprise Private Limited and Tamil Nadu Urban Infrastructure Financial Services Limited 2009, p. 21-27). In the United Kingdom, however, His Majesty’s Treasury (2005, p. 47) expressed a preference for cost effectiveness analysis (CEA) in which the objectives may be qualitative targets vis-à-vis the emphasis of cost-benefit or benefit-cost analysis on monetized values. An approach to appraisal that emphasizes on objectives like the CEA is the 2007 Asian Development Bank interim guidelines for enhancing poverty reduction impact of road construction projects (Kafle 2007). Musgrave and Musgrave (1989, p. 137-143) pointed out that benefits and costs can be real or pecuniary, direct or indirect, tangible or intangible, and inside or outside. Economic benefit assessments consider on real benefits and costs. Further, what differentiates economic from financial valuation is the inclusion of intangibles in the former while the latter consider only items that are tangible or those that have immediate monetary values in the market. The approach of Musgrave and Musgrave (1989) differs in a major way from the perspective of Stiglitz (2000) on economic valuation. Like Stiglitz, Musgrave and Musgrave attempt to assign or provide monetary estimates on intangibles. However, unlike Stiglitz, Musgrave and Musgrave concede that there intangibles in which assignment or estimation of monetary values are inappropriate (1989, p. 140) and points that the political process can make the decision on the provision of the good or execution of the initiative. In contrast, the perspective of Stiglitz (2000, p. 274) insists that values should be monetized. The Stiglitz framework is clear based on how he defined economic valuation, which is “developing systematic ways of analyzing costs and benefits when market prices do not reflect social costs and benefits” (Stilts 2000, p. 274). Thus, while Musgrave and Musgrave concede that there are ultimately projects, initiatives, and goods in which assignment or estimation of monetary values is inappropriate, the Stiglitz perspective does not make that concession. The two approaches on how valuation is achieved in the work of Musgrave and Musgrave and Stiglitz are probably not original. A number of economists may be the actual forerunners of what they have written.1 However, the difference between the basic two approaches probably represents the two fundamental schools of thought in economics with regard to how benefits or net benefits of investments, projects, or initiatives are determined. Risk Analysis In risk analysis, uncertainty is explicitly introduced into the project appraisal to identify and focus on the key variables on which one may wish to acquire better information (USAID India Reform 2011, p. 119). According to the USAID India Reform (2011 p. 119), the alternatives available for risk analysis includes sensitivity analysis, scenario analysis, and Monte Carlo Simulation (MCS). Salling (2007, p. 7) enumerated a seven-stage approach to Monte Carlo Simulations: 1. Identify the uncertain values or parameters. 2. Assign the appropriate probability distribution schedule to the uncertain values or parameters. 3. Identify the typical value of the uncertain values or parameters through sampling procedures. 4. Based on the earlier step, assess the cost-benefit ratio. 5. Repeat the process. 6. Identify the most likely benefit-cost value base and compare this with the extreme values. 7. Construct a probability distribution of the benefit-cost ratio. The description of Salling (2007, p. 7) on how Monte Carlo Simulations are implemented suggest that probability distribution schedules are not empirically derived. It is possible however to derive some of the probability distribution schedule based on experience while some of the probability distributions schedules or patterns can be assumed for convenience in analysis. Meanwhile, based on analysis of risks, the net present value of the proposed project can be represented as a probability distribution or as a probability density function (Savvides 1994, p. 18-20). The probability distribution of the net present value of a project has an expected value that can the basis for deciding for or against a proposed project (Savvides 1994, p. 19). However, according to Savvides (1994, p. 18), the general rule is to “choose the project with the probability distribution of return that best suit one’s own personal predisposition towards risk”. Those who are not afraid of risks will most likely choose to invest in projects with high returns even if the proposed project is relatively risky (Savvides 1994, p. 19). In contrast, those who shun risk will most likely choose proposed projects with relatively modest returns provided they are less risky (Savvides 1994, p. 19). Thus, while the expected value techniques can suggest the mathematically derived net present value of a proposed project based on analysis of risks confronted by a proposed project, the decision whether to accept or reject a proposed project will not depend on the mathematically derived value of the net present value of a proposed project. Instead, the decision to invest or proceed with the project will depend on the risk profile confronted or will be confronted by the project. As mentioned, risk adverse individuals may favor projects that are less risky over projects with high expected returns but are risky. Yet, the same time, the net present value of the project will depend not only the risk profile but also on the discount rate adopted for the proposed project (Savvides 1994, p. 21). How the net present value of the project will vary as the adopted discount rate for the project varies is covered by sensitivity analyses. It goes without saying that adopting the net present value approach for accepting or rejecting proposed projects that uses risk analyses in the determination of the risks assumes that all benefits and costs can be monetized. As suggested by our earlier discussion on the perspectives implied in the work of Musgrave and Musgrave versus those in Stiglitz, the approach of Stiglitz is to “develop ways” of monetizing even the intangibles while that of Musgrave and Musgrave is to do the same but with a proviso to concede that monetizing benefits and costs are not always feasible. Drawing from several years of experience in benefit-cost analysis, Savvides identified the advantages of risks analysis as a tool for making investment decisions (1994, p. 27): 1. It enhances decision making for projects with small net present value. In particular, a proposed project with a low net present value can still be favored if the risk profile of the proposed project is low. 2. Risk analyses can screen new project ideas and promote the identification of investment opportunities. For example, inadequate project data can be reflected as large uncertainties and can discourage projects that have too many unknowns. 3. The use of risk analyses highlights the need for further investigation and collection of information. 4. Risk analysis information can aid project design or that projects may be redesigned to take account of the predisposition of investors towards risks. Following Savvides’ argument, as the negative risk profile associated with a road project is typically small, road projects can be favored by a risk analysis approach to road projects. Writing on risks analysis as applied for road construction projects in Japan, Sato et al. (2005, p. 3972) pointed that risk analysis can be defined as the chance of a loss, possibility of a loss, or uncertainty. Sensitivity Analysis For the USAID India Reform, in sensitivity analysis we assess how changes in the values of a variable can affect the Net Present Value of the cash flows of proposed project as the rest of the variables are held constant (2011, p. 120). Thus, sensitivity analyses are also known as “what-if” analyses (USAID India Reform 2011, p. 120). Some of the values that can be covered by sensitivity analysis include how the net present value of the proposed project can be affected by changes in what discount rate to use, what wage rate to assume, and how the present value would be affected with changes in the price of inputs such as oil. In conducting sensitivity analysis, a project appraiser identify the main or major sources of risks and assess how the project will be affected based on the changes in the values of variables identified as major or main sources of risk (de Castillo 1998, p. 6). In a road improvement project for example, some of the concerns for sensitivity analysis includes a 20% increase in costs, vehicle operating costs, traffic jams, absence of traffic growth, presence of generated traffic, and the like (Asian Development Bank 2010, p. 5). Conway (2010, p. 21) emphasized that “all cost-benefit analysis, in fact, should be tested for sensitivity to the discount rate.” According to Conway, sensitivity analysis of a proposed project to changes in the discount rate is especially important because “there is no right answer” to the choice of the discount rate and, thus, assessing the sensitivity of a proposed project to the discount rate enables decision-makers to make better judgment (Conway 2009, p. 21). Further, “discounting can lead to seriously undervaluing environmental resource which return benefits over long time horizons” (Conway 2009, p. 21). On this matter, analysts favor a discount rate in the 7-15% range which are “commonly adopted without much consideration” (Conway 2009, p. 22). He emphasized that “economists should be discouraged from casual acceptance of a discount rate without testing for sensitivity to the discount rate to make sure that the results of the cost-benefit analysis do not border on the ridiculous” (Conway 2009, p. 22). At the same time, Conway (2009, p. 24) also pointed out that “common sense should prevail over slavery to a determined discount rate” (Conway 2009, p. 22). In the United Kingdom, even if the cost-effectiveness analysis is favored over the benefit-cost analysis, the use of sensitivity analysis is prescribed “to demonstrate the different choices available to decision makers” (HM Treasury 2005, p. 4). The HM Treasury (2005, p. 29) even emphasized that as result of uncertainties, “scenario and sensitivity analysis should always be used” (HM Treasury 2005, p. 29). In Europe, a high majority of the 27 countries covered by the assessment of Odgaard et al. (2005, p. 91) use sensitivity analysis in assessing worthiness of proposed projects. Toigo and Woods (2006, p. 82) confirms the use of sensitivity analysis for public investment decisions in the United Kingdom. In doing sensitivity analysis, professional appraisers recommended that an important requisite for doing sound sensitivity analysis is the determination of the magnitude of a variable’s fluctuations or its plausible changes in values (Infrastructure Professionals Enterprise Limited and Tamil Nadu Urban Infrastructure Financial Services Limited 2009, p. 25). However, they also pointed out that appraisers should be competent as well to determine the extent to which the volatility of the variable can be controlled. Academics from the North Carolina State University pointed out that sensitivity analysis can be categorized as mathematical, statistical, and graphical (Frey and Patil 2001, p. 12). Triantaphyllou and Sanchez (1997, p. 194) pointed out that the mathematical sensitivity analysis findings can even be presented in the form of mathematical models. However, it is probably possible to conceive of a sensitivity analysis that that are qualitative rather than quantitative. For example, a project may be favored or not favored by political climate: a group of politicians may not favor a project when they are not in power while another set may favor a project when they are the ones in power. In summary, our modest review of literature on economic benefit estimation and risks/sensitivity analysis suggests that while the methods of project appraisal have developed (including those for road projects), there is still ample room for refining the techniques. References Asian Development Bank, 2010. Economic Analysis. Available in: http://www.adb.org/Documents/RRPs/CAM/42334/42334-01-cam-ea.pdf (Accessed 29 April 2011). Conway, T., 2009. Supplemental cost-benefit economic analysis guide. Resource Future International. De Castillo, C., 1998. Economic analysis of social investment fund projects. Washington: The World Bank. Federal Emergency Management Agency, 2006. 2006 Guidelines for benefit-cost analysis. Available from: www.scemd.org [Accessed 29 April 2011]. Frey, H. and Patil, S., 2001. Identification and review of sensitivity analysis methods. North Carolina State University. Available from: www.ce.ncsu.edu [Accessed 29 April 201]. HM Treasury, 2005. Managing risks to the public: appraisal guidance. London: HM Treasury. Infrastructure Professionals Enterprise Private Limited and Tamil Nadu Urban Infrastructure Financial Services Limited, 2009. Project Appraisal Manual. A submission to the Asian Development Bank. Kafle, M., 2007. Interim guidelines for enhancing poverty reduction impact of road projects (Nepal: Enhancing poverty reduction impact of road projects). Kathmandu: Department of Roads. McElhinny, V., 2010. Troubling implications for investment lending reform. IFI Info Brief. Washington: Bank Information Center (BIC). Musgrave, R. and Musgrave, P., 1989. Public finance in theory and practice. 5th Ed. New York and London: McGraw Hill. Odgaard, T., Kelly, C., and Laird, J., 2005. Current practice in project appraisal in Europe. European Union: Contract FP6-2002-SSP-1/502481 (Lead Contractor: COWI A/S, Denmark). Sailling, K., 2007. Risk analysis and Monte Carlo Simulation within transport appraisal. Available from: http://www.systemicplanning.dk/Risk_Analysis_-_Technical_note.pdf [Accessed 19 April 2011]. Sato, Y., Kitazume, K., and Miyamoto, K., 2005. Quantitative risks analysis of road projects based on empirical data in Japan. Journal of the Eater Asia Society for Transport Studies, 6, 3971-3984. Savvides, S., 1994. Risk in investment appraisal. Reprint of Project Appraisal, 9 (1), 3-18. Beech Tree Publishing. Stiglitz, J., 2000. Economics of the public sector. New York and London: W.W. Norton & Company Ltd. Triantaphyllou, E. and Sanchez, A., 1997. A sensitivity analysis approach for some deterministic multi-criteria decision-making methods. Decision Sciences, 28 (1), 151-194. USAID India Reform Project, 2011. The project appraisal practitioner’s guide. United States Agency for International Development (USAID)-India. Toigo, P. and Woods, R., 2006. Public investment in the United Kingdom. OECD Journal on Budgeting, 6 (4), 63-102. Read More