Votume 2 ADVANCED MANUAL ON ProJect EVALUATION Philippine¢Copyright @ 2006 by the Natiétial Economic and Development AuthorityTaBLe oF ConTENTS VoLume 2 Apvancep MANUAL ON ProJect EVALUATION 1 Provect EVALUATION OBJECTIVES: 44 12 13 14 Inodution Efficient Use of Resources 124 ThePareto-Optimaliy Criterion 4.22 ThePotenfalPareto Optimality Criterion Box 1-1 Pareto Optimality 4.23 Problems with Using the Potential Pareto Improvement Criterion 1.24 Potential Pareto Improvementin he Presence of Distorbons Box 1-2 Market Failures Sustainable Development Social Objectives 1.41 Distibusonal Analysis 142 Meeting the Basic Needs ofthe Most Needy 2 Proyect EvaLUATION CRITERIA 2A 22 23 24 25 “The Net Present Value (NPV) Criterion Intemal Rate of Retum (IRR) Criterion BenefCostRaio (BCR) Criterion Ranking Mutually Exclusive Projects wit Diferent Lives Optimizing Project's NPV 251 Optimal Timing 252 — Optimal Scaleofinvestment 3 ConcEPTS IN FINANCIAL ANALYSIS 3a ‘The Use of Consistent Prices in Financial Appraisal: Infition Treatment 3.11. Conceptof Nominal and Real Prices 34.2 — Useof Nominal Prices in Financial Analysis 3421 Directetlects 3.1.22 _Effectontaxrelated factors ‘Annex to Chapter3: Guide to Financial Ratios A31—LiquidtyRatos 832 Assot Utilization Ratios 833 CoverageRatios ‘834 Leverage Ratios 435. Proftabity Ratos ‘Tans oF Conrents 2 SRRs SESRABSSARSVoume 2, Apvaycep Manual. on Prosser EVALUATION 4 PRINCIPLES UNDERLYING THE Economic ANALYSIS OF PROJECTS 44 Iniroducton 42 Postulates Undertying the Eoonomic Evaluation Methodology Box4-1 Harberger's Three Postulates 43 Estimation of Economic Prices 43.1 Undistorted Markets 43:4 Analyzing the economic costs and benefits in an existing industry (nonew projec) 43.1.2 Analyzing the economic benef of an output produced bya project inan undistorted market 4.3.13 Analyzing the economic cost of aninput demanded by a projectin anundstorted market 44 Marketswih Distortions orExtemaities Box 4-2 Accounting for Taxesin Economic Appraisal 48 Definition ofthe EoonomicExtemaity 454. Environmental Externalities Box 4-3 Sources of Environmental Exteralty 45.1.1 Accounting for environmental extemaltiesin project appraisal 452 Congestion Extemalies m geese 8 SBBIB BB Box4-4 Measuring Congestion in Road Transportation m 453 Common Property-Resources Externalities B 454 Monopoly Externalities %4 455 Tax, Taiff,and Subsidy Extemalties 7 455.4 Taxand subsidyin the market of non-radable goods 6 4552 _Importduty and exporttaxin the market tradable goods 7 458 Foreign Exchange Externalty 8 457 — LaborExtemaity 2 458 BasicNeeds Externalities 9 48 Economic Benefits Including Exteraltios 80 47 Economic Costs Including Externalities 81 48 Conclusions @ 5 Estimatinc Economic Oprortuniry Cost oF CAPITAL 8 54 Empitical Estimation 8 6 Esimatinc Foreign EXxcHANGE PREMIUM % 6.41 BasicConoept % 62 Detaled Framework 8 63. Empirical Estimation 103 7 Estimation oF Economic Prices For Traoas.e Goons AND SERVICES 106 7.1 Iiroduion 106 72 Tradable and Non-Tradable Goods 107 73. Estimation of Economic Prices at the Port: Adjusting for Trade 110 Distotions and Foreign Exchange a Tanti or Contents734 74 Estimation of Economic Prices athe Project Adjsting for Handing and Transportation Costs 112, Estimating Commodity-Spectic Conversion Factors 75 Eoonomic Prices atthe Projector the Phippines 754 752 753 8 Estimation oF Economic Prices For Non-TRADABLE Goons AND SERVICES Project Uses An Importable Input Projet Produces An Exportable Output (Tomato Paste) Project Produces An impor Subsitude Output (Tomato Paste, Year One ofthe Project) 84 Inroduction ata 82 Case! 824 322 83 Case2: at 832 84 Cased 844 842 85 Cased: 854 852 86 Cases: 861 862 Economic Prices for Non-Tradable Goods in Distorted Markets 81.1.1 Analyzing the economic benefits ofan output produced bya projectinacstored market 8.1.1.2 Analyzing the economic costs of an input demanded bya projectina distorted market ‘AProject Producing ANon- Tradable Output Estimation of Economic Prices IMustrative Example: Project Providing Campsite Nights ‘Project Producing ANon- Tradable Output Economic Price of Non: Tradable Ouput with Adjustment forthe Foreign Exchange Prerrum ltustaive Example: AProject Providing Hote Room Nghis 832.1 Esimatinofthe economic price ofhotloom rights indomesticcurency Project Using ANon- Tradable Intermediate Good Estimation ofthe Economic Pre ofan Intermediate Good Used AsAn Inputof aProject Husraive Example: AProject Using Bricks ASAn Input 8421 _ Estimation ofthe economic price ofbricks ‘A Projet Using ANon Tradable intermediate Good As An Input Esmaton ofthe Econorrc Price of An Intermediate Good vith Dstrionsin Bot the Marke for tre nlemediate Good andits Factors Markets usratve Example: AProject Using Bick as an input when Distoions Exstn he Market Clay and Furace Oi 852.1 Estmatonofthe economic price ofbriksin domesiccurency [AProject Using A Non-Tradable Intermediate Good As An Input Estimation of Economic Price of An Intermediate Good wit Distorfonsinthe Market ofthat Good llustaive Example: Project Using Elect As An Input ‘when Distortions Exitn the Mark forts Subst: Diesel Oi 8621 Estimation of heeoonomicprceofelectiaty 87 Economic Prices for Non-Tradables inthe Philippines a4 872 873 874 Transportation Services Communicaons Consirucion Electcity 88 Measuring the Economic Value of Potable Water ‘Taaue oF Contents tt 112 13, 115 118 21 tat 121 121 123 125 12 wr 128 12 132 132 133 135 135 136 137 139 40 “2 143 144 145 146 “ar 187 169 161 164Voume 2, Apyancep Manual on Prosucr EVAWuaTiON 88.1 The Economic Benefits of Wash Water for Paying Consumers 882 The Economic Value of Drinking Water for Paying Consumers 883 The Economic Benefits of Water for Non-Paying Consumers 884 Numerical llustration ofthe Economic Benefits of Water Supply 9 Estimation oF Economic Opportunity Cost oF Labor oa 92 93 94 95 97 Inroducon 9.1.1. Estimation ofthe Economic Opportunity Costof Labor 9.1.1.1 Value ofmarginl produc ofabor foregone approach 9.1.12 Supply price oflabor approach 9.42 Structure of Analysis ‘The Economic Opportunity Costof Unskiled Rural Labor 9.2.1 Introduction 922. Supply-Price Approach: Calculations ‘The Economic Opportunity Costof Skilled Labor 93.1 Introduction 932 Supply-Price Approach: Calculations 932.1 Labormarketwithoutdstortions or regional migration 9.322 Workers migrate to project rom cistorted regional labor markets 9323. Labormarketesteralties Economic Opportunity Cost of Labor with ntemational Migration Flows, ‘The Eoonomic Opportunity Costof Foreign Labor EOCL When Labor s Not Employed Full Time 96.1 Labor Employed Lessthan Full Yearin MarketActhites 9.62 Permanent and Temporary Jobs with An Unemployment Insurance System and Labor Migration Conclusion ‘Annexto Chapter9: Estimation of the Economic Cost of Labor Applications forthe Philippines ASA Reallnorease inWage Rate A92 The Economic Opportunity Cost of Unskiled Labor Case 1: Projecthires unskited rural labor and pays prevailing market wage 165 165 16 166 12 172 173 173 173 175 7 1 7 180 180 181 182 182 184 185 186 188 188 189 12 14 14 195 1% Case: Projecthires unskiled rurallabor and pays wages higher than market 196 Case: Projecthires unskied rua laborin region where market wage rate varies seasonally 1% Case 4: Project demands unskilled workers for ciilworks n an ubanregion 197 93 The Economic Opportunity Cost of Skies Labor Case':_ Projecthies skied lborin the National Capital Region NCR) and pays market wage Case6:_Projecthires skied labor nthe NCR and pays wages above the market rate Case’: Projectirs skied iabor outside NCR and pays nancial wages above the market rato 9.4 Economic Opportunity Cost of Laborif Project tracts Overseas Fliinos Case 8: Hing by projctinduces the retum of Fipino workers employed overseas 95 Economic Opportunity Cost of Foreign Labor Employed the Phifppines Case 8: Projectires foreign technical advisorin Ease Visayas 197 1% 8 BB RR OB ‘Tase oF ContextsVowwme 2. Apvaxcen Masvat. on Prorgcr Evanuarion 10 DEALING witH UNCERTAINTY IN PRoJEcT DEVELOPMENT AND APPRAISAL 205 101 Incremental Cashflow Projections with Uncertainty 25 4041 Trend, Cycle, and Error Terms 206 1012. The'Whte Noise” Mode! an 1013 Random Walk 23 410.4 Random Walk with Drift 213 1015 Autoregressive Models 24 104.6 Projecting Revenues and Costs with Uncertainty 218 402 Using Contracts to Manage Risk 224 1021 RiskRe-Alocation 224 4022 Contracting Risk a 1023 Inventive Elects 28 ‘Annex A Pustic Provision oF Goons AND SERVICES 228 AA Inoducton 9 2 _Notesonthe Allocation Function 2 Annex B A Summary oF THE INTEGRATED PROJECT PROPOSAL 245, Appraisat MetHopoLocy B41 Introduction B2 Integrated ProjectAppraisal B3 Conclusion ‘Annex C Tue Economic Aspect oF FOREIGN FINANCING C4 nroducion C2_—_Measurement ofthe Benefits from Incremental Foreign Investment C3. The Benaftfom Reallocating Foreign Investment Already Presentin the Host Country C4 Conclusion ‘Annex D ‘Tue Economic Cost oF Risk D4 Inroducion D2 Accounting for Riskin a Projects Retun D3 Incorporating Riskin Financial Analysis D1 —Costof Funds Demanded by Investors D32 Using CAPM 33. Working with Certainty Equivalent Cashfiows, D4 Economic Costof Risk DAA Risk-Sharing Argument D42 —_Risk-Pooling Argument DA3__ Risk-Neutalty Argument DS Conclusion 285 25 28 285 285 286 2 20 me 22 28 25 25 296 296 aT 28 29 29 29 ‘TaBLe oF CowrentsVowe 2, Apvanceb Manual ox Protect EVALUATION ‘Annex E PROJECT FINANCE AND PRIVATE SECTOR PARTICIPATION 301 ww Pustic Sector Activimies 1 Inoducon ao 2 — WhatisProjectFinance m2 E3 Why ProjectFinance 3 E4 —_ProjectRisks, Contractual Arangements 06 and Other Mitigation Mechanisms £5 _ProjectFinance issues and Considerations forthe Host County 313 E6 Private SectorPartcipationin Public Sector 34 Actives: The Buil-Operate-Transfer (BOT) ‘Approach to Infrastructure Projects E61 GovemmentRole 316 E62 Concessionaire's Perspective 317 E63 Funders’ Perspective 317Vous 2. ApvaNcep Mavuat ox Prosscr Evatvaniox List oF Tastes Cuapter 2 — ProJect EvALuaTiON CRITERIA Table 2-1 Problems wit the IRR Citron 8 Table 22 Problems with Mutually Exclusive Projects 8 Table23 Problems wth Mul-Period rojacts “4 Table 24 Problems with Projects of Diferent Scale 6 Table 25 Net Cashfiows of Mutualy Exclusive Projects a Table 26 Repeating Project Lives to Equalize Mutually Exclusive Projects a Table27 Determination of Optimum Scale of An Irigaton Dam 2 CuapteR3 — ConcerTs IN FINANCIAL ANALYSIS Table 41 Project XYZ Financing 2 Teble32 Project XYZ Cash Balance 8 Table3-3 ‘Cash Balance with 25% Infation 8 Table34 ‘Accounts Receivable 4 Table 35 Accounts Payable 4% Table3-6 Nominal Interest Rate ofS a Table 37 Nominal nterestRte of31.25% a Table 38 Comparison ofRealCashfows 48 Table 39 interest Expense ry Table 3-10 Project XYZ: Depreciation Allowance ry Table 3-11 Inventory and Cost of Goods Sold- FIFO 50 Table 3-12 Inventory and Cost of Goods Sold-LIFO @ Cuapter5 — Estimating Economic Opportunity Cost oF CAPITAL TableS-1A —_RetumtoDDomesticInvestmentinthe Philippines, 1946-1996 Expressed in Nominal Terms TabieS-1B Capital Stock Expressedin Real Pesos 8 ‘Table52 Economic Costof Capital Estimation for 1996, % Cxapter6 — Estimarinc Foreicn ExcHaNce Premium Table64 ‘Trade Statistics, 1902-1904 104 Table62 Domestic Sales and Excise Taxes 105 Table63 Decompostion of FEP 105 Chapter 7 — Estimation oF Economic Prices FOR TRADABLE Goons Table 7-1 Project Uses An Importable Good (Packaging Material) 116 Table 7-2 Project Supplies An Exportable Good (Tomato Paste, Year 2 onwards), 7 Table 73 Project Supplies An Importable Good (Tomato Paste, Year One) 10 List oF TaBLesoun 2. Apvaxcep Manual. ox Proskr EVALAIATION Chapter 8 — Estimation oF Economic Prices FoR Non-TRADABLE Goons AND SERVICES Table 6-1 Relationship between Market Prices and Demand and Supply 131 Prices with Various Types of Distortions. Table8-2A National Transport Demand, 1994 148 ‘Table8-28 Average Growth Rates of Freight and Passenger between 1987-1994 148 ‘Tabie8-2C Wale Transport and Average Growth Rates of Cargo and Passenger 149 between 1987-1997 Table83 Cost Structure of Road Transport Services, 1990 149 Tableb4 Estimaton of Conversion Factor. Road Transport Services 190 Table8s Cost Structure of Philippine National Raiways, 1994 ‘61 Table8 6 Estimation of Conversion Factor Railway Transport Services 182 Table 87 Cost Structure for Water Transport and Related Services, 1990 13 Table8S Estimaton of Conversion Factor Water Transport and Related Services 14 Table8 9 Cost Structure fort Transporation, 1200 155 Table 8-10 Estimation of Conversion Factor: Air Transportation 186 Table 8-11 Cost Structure for Communications, 1990 157 Table 8-12 Estimation of Conversion Factor Communication 188 ‘Table 8-13 Cost Structure for Construction, 1990 189 Table 8-14 Estimation of Conversion Factor: Construction 100 Table 8-15, Cost Structure ofthe National Power Corporation, 1985 162 Tableb16 Estimation of Conversion Factor: Electcity 163 Cxarter9 — Estimation of Economic Opportunity Cost oF LaBor Tablet Project Hires Unskiled Laborina Rural Area 179 Table92 UnemploymentRates 192 CwaPTER 10 DEALING WITH UNCERTAINTY IN PROJECT DEVELOPMENT AND APPRAISAL Table 10-4 Forecast of Real Raw Sugar Prices 210 Based on Estimated Trend & Cycle of Past Prices (1997-2001) Table 10-2 ‘Simulaon Resuits forthe “White Noise" Modelof Real Raw Sugar Prices 22 Table 10-3 Forecast ofReal Raw Sugar Prices 24 Based on a Random Walk Mode with Drift (1997-2001) Table 10-4 Forecast of Real Raw Sugar Prices Based on Estimated First-Order 216 ‘Autoregressive Model of Past Prices (1997-2001) Table 105 Forecast of Real Raw Sugar Prices Based on Estimated Second-Order aT Autoregressive Model of Past Prices (1997-2006) Table 10-6 Observationon P, Q, and Q, 219 Table 10-7 Joint Probability Distribution of Pand Q, 2 Table 10-8 Joint Probability Distribution of Pand Q, 2 Awnex A, Puatic Provision of Goons AND SERVICES Tablet Possible Sources of Economic Benefits and Costin Various Projects ca IST OF TABLESAnnex B Table 1. Table 1.8 Table 1.C Table2 Table3 Tabled TableS.A TableS B Tables Table7 Tables Tableg Table 10 Table 11 Table 12 Table 13 Table 14 Table 15 Table 16 Table 17 Table 18 Table 19 Annex E Tablet TableE2 List oF Tastes ‘A Summary OF THE INTEGRATED PROJECT PROPOSAL APPRAISAL METHODOLOGY Table of Parameters, Table of Parameters Table of Parameters for Economic Analysis Inaion Rates, nfation Indices and Exchange Rates Production and Revenue Schedule Direct Cost Schedule Investment Table Depreciation Schedule ‘Working Capital Schedule Grants (in milion Pesos) Nominal Nominal Net Beneft Statement Cashviow ‘Total Investment Perspective Real Net Beneli Statement Cashow Totalinvestment Perspective ‘Nominal Net Beneft Statement Cashflow Ezquity Holder's Perspective Real Net Benefit Statement Cashiow Equity Holder's Perspective Conversion Factors ‘Statement of Economic Resource Flow Slatementof Extenalies Distibution of Extemalies Reconciiaton ofthe Economicand Financial Statements ‘Sensitivity Analysis Risk Analysis of Hospital Project Risk Analysis of Hospital Project Risk Analysis Results Provect FINANCE AND Private SECTOR PARTICIPATION IN Pustic Sector Actives Defriton Spectrum for Project Finance Main Reasons forthe Emergence and Use of Project Finance SSS 8 8 8 YPSRPSBBVVwwList oF Figures Charter 2 Provect Eva.uarion Criteria Figure 2-1 “Time Profies ofthe Incremental Net Cashflow for Various Types of Projects 1 Figure2-2 Mutually Exclusive Projects withthe Same Scale 15 Figure2-3 Timing of Projects when Potential Benefts Are a Continuously Rising Function ofCalendar 28 Time butAre Independent of Time of Starting Project Figure24 Timing of Projects When Both Potential Bnefts and investments, a ‘Are Function of Calendar Time Figure25 Timing of Projects Wen Potential Benefits Rise and Decine with Calendar Time 2 Figure 2-6 Timing of Projects Wnen Patems of Both Potential Benefits and Costs 0 Depend on Time of Starting Project CuaPTeR4 —- PRINCIPLES UNDERLYING THE Economic ANALYsis oF PROJECTS Figure 4-1 Evonomic Costs and Benefits (No New Project in Undstorted Market e Figure4-2 Economic Benefits ofANew Projectn An Undstoted Market a Figure4-3 Economic Cost ofAn Input Demanded by AProjectn An Undistorted Market 6 Figured-4 Market or Fish without Environmental Exteralty 70 Figure 4-5 Market for Fish wth Poltoninthe Lake 7 Figure 4-8 Congestion on Aad or Bridge 2 Figure4-7 Private Ownership vs. Common Property Arrangement 7% Figure4-8 Monopolistic Markt % Figure4-9 Taxon Non-radable Goods 7 Figured-10 Subsidy on Non-Tradable Goods 7 Figure4-11 _Distotion Due toAn port uty 7% Figure4-12 Distortion Caused by An Export Tax 78 Figure4-13 Basic Needs Externalities @ Figure4-14 Economic BeneilofA Project the Presence of Externalities at Figure4-15 Economic Costs of AProjectin the Presence of Extemalies, 2 Cxapter6 — EsTIMATING ForeIGN EXCHANGE PREMIUM Figure 6 Deteminationof p, 9 Figure 6-2 Foreign Exchange Market Determinationof p, % Figure 6-3 Determinationof p, 100 Cuapter 7 — Estmarion oF Economic Prices For TRADABLE Goons Figure 7-1 Tradables and Non-Tradables 108 Figure 7-2 Example ofA Project that Uses An Importable Good (Packaging Material) 114 Figure 7-3 Example ofAProjec that Produces An Exportable Good (Tomato Paste) 116 Figure 7-4 Example ofA Projectthat Supplies An Importable Good (Tomato Paste, Year One) 119 List oF FicusCuarter 8 Figure 8-1 Figure 8-2 Figuree-3 Figure 8-4 Figure 8-5 CHaprteR 9 Figure 9-4 Figure 9-2 Cuaprer 10 Figure 10-1 Figure 10-2 Figure 10-3 Figure 10-4 ‘ANNEX A Figure A-t Annex B Figure B-1 Figure B-2 Figure B-3 Figure B-4 Figure B-5 Figure B-6 ‘Annex E Figure E-1 List oF Fiovass EstimaTion oF Economic Prices FOR NON-TRADABLE Goons AND SERVICES Economic Benefits ofANNew Projectin A Distorted Market Economic Cost of Input Demanded by AProjectin A Distorted Market Economic Benefts of Project Output (No Distortions) Economic Benefts of Project Output (Taxon Output) The Economic Benefits of Water to Paying Customers Estimation oF Economic Opportunity Cost oF LABOR ‘Seasonal Patter of Agricultural Wages Regional interaction between Skiled Labor Markets DEALING witH UNCERTAINTY IN Prosect DEVELOPMENT AND APPRAISAL. ‘Annual Nominal and Real Sugar Prices (Annual Averages of Monthy Data) (January 1981 -June 1998) Trend ofAnnual Real No. 11 Raw Suga Prices (1981-1996) Trend of Real No. 1 Raw Sugar Prices (1962-1996) Predicted Trend and Cycle for Real No. 11 Raw Sugar Prices (Based on a Si-Year Cycle) (1982-1996) Pustic Provision of Goons AND SERVICES Public and Private Provision with Postive Externalities, A Summary OF THE INTEGRATED PROJECT PROPOSAL APPRAISAL METHODOLOGY Tables for Financial Appraisal Stepsin Economic Appraisal Distributive Analysis of AProject Sensitivity and Risk Analysis RiskAnalysisof Hospital Project Cumulative Distrbuion ofNPV-c0 Risk Analysis of Hospital Project Frequency Distribution ofNPV-Eco PROJECT FINANCE AND PRivaTE SECTOR PARTICIPATION IN Pusuic Sector Actives Relationship Among Principal Parties to A BOT 12 123 126 12 167 178 181 Be 210 230 eT 21 255 28 28 29 315Voume 2. Apvaycen Maxvas, on Prosecr Evawvari Cuapter 1 Provect EvaLuation OpJectives 11 Introduction Project evaluation is a methodological framework designed to assist the national government, as represented by the Investment Coordination Committee (ICC) for major national projects, in deciding ‘whether or not a capital investment is in the best interests of the country. It is the task of the ICC to review and evaluate major capital projects with respect to technical, financial, economic, social and institutional feasibility and viability, as well as from the context of sectoral plans and geographical strategies, and to recommend approval to the NEDA Board. Major capital projects are currently defined as those investments with total costs of PhPS00 million and above regardless of financing. These also include projects to be implemented in partnership with the private sector and the local government units (LGUs). The ICC Guidelines and Procedures provides detailed information on the coverage of ICC review of public investments. ‘The economic and social objectives of project evaluation are to identify and promote the approval of investments that: a)_use resources efficiently (refer to Section 1.2), 'b) promote sustainable development (refer to Section 1.3), ©) treat individuals equitably by ensuring that no specific group is materially disadvantaged as a result of an investment (refer to Section 1.4.1), and, 4) improve the level of basic needs of the most needy (refer to Section 1.4.2). A indicated above, the various objectives are examined in detail in subsequent sections 1.2 Efficient Use of Resources In order to ensure that only those capital investments that make efficient use of the scarce ‘economic resources, both in the private and public sectors, are approved and promoted, itis necessary to adopt a set of suitable criteria, The theoretical basis and practicality of the different possible criteria are discussed below.’ 1 The eriteria discussed here are from Welfare Economics. See Layard PR.G and A.A, Walters, “Microeconomic Theory,” ‘McGraw-Hill (1978) for a detailed discussion. Giapran 1.” Proseer Evaiuanion Onmonves i1.2.1 The Pareto-Optimality Criterion One criterion used by economists to determine if resources - land, labor, capital, and natural resources - are allocated efficiently is the Pareto-optimality criterion. A project that alters resource allocation by drawing resources away from their altemative uses can be said to improve economic efficiency if at least one individual is made better off and no one else is made worse off. A Pareto ‘optimum occurs when resources can no longer be reallocated to make some economic agents better off without making one or more individuals worse off. This is a very rigorous standard. Since it would be difficult to find projects that do not have any detrimental effects even for one person, itis not a practical standard for real-world applications. Pareto optimality and the premise underlying it are presented in Box 1-1? 1.2.2 The Potential Pareto Optimality Criterion An alternative criterion used more often is the potential Pareto improvement criterion in resource allocation. A potential Pareto improvement occurs when the gains to those who benefit from a project are sufficient to compensate those who are made worse off and still leave a residual benefit. This residual benefit is the net gain to society as a whole. Only if this net gain is positive can a project claim to make efficient use of resources. Ideally, we would like the net gain to be as large as possible. If the net gain is negative, then the winners would not be in a position to compensate the losers, and society as a whole would be worse off. Box 1-1 Pareto Optimality Pareto optimality is criterion used to evaluate a change in resource allocation. A Pareto ‘optimum occurs when resources can no longer be reallocated to make some economic agents better off without making one or more individuals worse off. The changes that make some better off without making anyone worse off are referred to as Pareto improvements. Although it might be difficult to design a single change to constitute a Pareto improvement, package or packages of changes together may meet this criterion. The belief that any such improvernent should be instituted is referred to as the Pareto principle. An important property of the Pareto optimality criterion is its individualism. Firs, itis concemed only with each individual's welfare, not with that of different individuals. It does not look at ‘inequality, or the gap between the rch and the poor. Therefore, there would still be a Pareto improvement in the case of a change that makes the rich much better off and leaves the poor ‘unaffected, which would ultimately result ina bigger gap between the two. Second, it iseach individual's perception of his/her own welfare that counts. Another criterion in evaluation of changes in resource allocation is the potential Pareto ‘optimality, or the compensation principle. Itevaluates whether the peso value of a change to ‘those who benefit from this change exceeds the peso value of the loss to those who become worse off. If it does, then the residual benefit is a net gain to the society as a whole. This principle makes the implicit assumption that a peso’s worth of gain to one individual should weigh the same as a peso’s worth of loss to another. ¥ See Sugita, Joseph E., "Economics ofthe Public S Pareto Optimal improvements or (chapter 3)" fora discussion of Pareto Optimality and Potential (Cuaeren 1.” Prosser EVAUsATION OBJECTIVESVounse 2. Apvaxcep Maxvat, ox Prosecr EVALUATION 1.2.3 Problems with Using the Potential Pareto Improvement Criterion One of the main problems with the potential Pareto improvement criterion is that it aggregates the changes in well-being or welfare experienced by individuals in different groups in the society, such as consumers, workers, owners of productive resources, owners of natural resources, taxpayers, cetc., who may either gain or lose as a result of a project. This criterion also requires that the loss in welfare of any group be compared to the gains experienced by other groups. ‘These interpersonal comparisons of welfare are complicated by the fact that the additional utility of an extra peso to someone who is poor may be greater than its value to someone who is rich. To avoid having to make such value judgments, we employ the operational rule that when measuring the net benefits of a project, a peso is valued as a peso no matter who receives it or who loses it. This convention greatly facilitates communication and understanding of the meaning of the results of the analysis as it will allow us not only to add up the changes in well-being for individuals ina given group, but also to net out the gains and losses across groups. 1.2.4 Potential Pareto Improvement in the Presence of Distortions Like most countries, the Philippines has a mixed economy. The economic decisions, to a large extent, are made in the private sector where both consumers and producers respond to market prices, which are in tum determined in either domestic or intemational markets. The allocation of resources between different activities depends upon the response of consumers and producers. On account of market failures, however, the public sector represented by the government has to intervene frequently in order to improve the allocation of resources. In addition, governments typically have their own agenda of political, social, and economic objectives they wish to implement. Depending on the criteria used to make these decisions, the resulting reallocation of resources from the private to the public sector can either improve or worsen the economic well-being of society. When there are perfectly competitive, undistorted markets, the private sector will allocate resources efficiently, and market prices will provide a measure of marginal economic benefit and ‘marginal economic cost. The term perfectly competitive, undistorted markets refers to those markets where consumers have freedom of choice and firms have freedom to enter and leave an industry, where exchange is voluntary, where market participants are fully informed (where there is symmetry in the information possessed by economic agents), and where there are no distortions like taxes, subsidies, tariffs, monopoly power, or pollution that drive a wedge between marginal economic benefit and marginal economic cost. Economists describe these conditions as the first-best equilibrium. Ifthey were valid for every industry, then a Pareto optimum would exist, and it would not be possible to improve the allocation of resources. When these requirements are not satisfied, then private markets alone cannot be relied upon to allocate resources efficiently, and market prices may no longer provide a reliable measure of marginal ‘economic benefits and costs. There are many reasons why markets fail to allocate resources efficiently Caabran 1.” Provscr Evaluanion Onsecrives 3‘Voume 2, Apvaxcen Manvat, ox Provact EvaLustion (Box 1-2)2 The ones that are of most interest to us can be grouped under the broad heading of externalities. Box 1-2 Market Failures ‘The term market failure refers to the situations when markets fail to allocate resources: efficiently. There are several sources of market failure, which are used to justify government intervention in the marketplace: 1. Failure of Competition or Monopoly. The market mechanism cannot allocate resources in an efficient way in the absence of competition. When there is only one firm in a ‘market, the monopolist, if unregulated, will restrict output to attain a higher price. A monopolist produces at the point where the extra revenue (marginal revenue) it would receive from producing an extra unit equals the extra cost of producing that unit (marginal cost). Thus, it will produce and sell a quantity Q,, at which marginal revenue equals marginal cost. That quantity is certainly less than the quantity Q_ at which price equals, marginal cost. At the equilibrium quantity Q, under monopoly, the price of the good, which measures how much individuals value an extra unit of the good, exceeds the ‘marginal cost. Thus, a monopolist underproduces and charges a higher price compared to a competitive industry, which results in a welfare loss from the restriction of output, Consumers would benefit more from increased consumption of the units from Q,, to Q, than it would cost the economy to produce them. Hence, there isan inefficient allocation of resources. In the long run and under perfect competition, a firm produces at the point where the marginal cost of production is equal to the average cost of production. This occurs at the lowest point of the average cost curve, thus, there is production efficiency in a competitive industry, This is not the case with a monopoly production, which is why it suffers from a lack of production efficiency. O Gianity "hse reasons ae reviewed in publi finance textbooks like Boadway and Wildasin (1984, Chapters 1 and2) and Stiga (1988, Chapters 4) 4 (Cuapren 1. Prouscr EvaLuxnion OniecrvisVous 2. AD (ce MaNvAl oN Prosper EVALUATION Box 1-2 (cont’d.) 2. Public Goods: The concept of public goods has two properties. First, it does not cost anything for an additional individual to enjoy the benefits of the public good (non-rival in consumption). Second, it is not possible to exclude individuals from enjoying the public ‘good. An example would be national defense. Therefore, itis very difficult or impossible to collect payments from the consumers of public goods. For these reasons, the private sector ‘will not supply public goods or will not supply them in sufficient quantity. The government has to take the role of a supplier of these goods or at least make provision for payment to private suppliers for their production, 3. Externalities: Instances where an individual's activities impose a cost on others are referred to as negative externalities. An example would be the case of environmental pollution, such as water pollution, wherein polluters impose the cost of cleaning the water on the users without compensating the latter for that cost. Positive externalities occur when an individual's actions confer benefits upon others. Government has to intervene in cases of externality to ensure that an optimum level of production is achieved. 4. Incomplete Markets: Whenever private matkets fail to provide a good or service, even ‘though the cost of providing itis less than the price that individuals are willing to pay, there is a market failure called an incomplete market. An example would be the insurance or the capital market where government regulatory or supervisory activities are needed in order to provide these services in an efficient manner, ‘5. Information Failure: Often the market supplies too litte information to consumers on. subjects such as product safety, and itis the role of the government to step in to remedy the information failures. Additional information often has a value to consumers that is greater than its production and dissemination costs. 6. Redistribution and Merit Goods: The government should also be involved in the economy for purposes of income redistribution and for the provision of merit goods. ‘The economy ‘can be Pareto optimal, and at the same time gives rise to unequal income distribution. ‘Therefore, government welfare activities can be designed to assist those in need and reduce the gap between rich and poor. Merit goods are those goods that the government compels individuals to consume, based. on the assumption that the individuals may not act in their best interest, so the government has to intervene because it is in its citizen’s best interest. Economists describe a situation where distortions drive a wedge between marginal economic benefit and cost as the second-best equilibrium (Meade, 1955). Since a Pareto optimum does notexist under these circumstances, iis possible to bring about a potential Pareto improvement in he allocation of resources either through policy changes, such as tax, trade or environmental policy changes, or by undertaking public sector capital expenditures that are designed to offset the distortion. It is important to recognize that these are conceptually two different types of exercise. Gitspran 1.” Paosecr EvaLuanion Oniecrivss 3Vowume 2. Apvancep Manual, on Prosecr Evatuavion Tax, trade and other policies, on the one hand, frequently involve changes in the level of distortions. For example, government employs fiscal instruments to alter the level of different taxes in order to improve the design of the tax system. By the same token, it adjusts the trade tariffs and subsidies to achieve the commercial policy objectives. On the other hand, when it comes to capital expenditure decisions, the standard practice is to take the level of distortions in all markets as given. Recognizing these distortions, project analysts face the challenge of estimating economic benefits and costs in order to determine whether a project is likely to bring about a potential Pareto improvement in the allocation of resources. This challenge is addressed by undertaking an economic analysis of the project. Since project analysts cannot rely on market prices to measure benefits and costs in a second-best economy, they will have to take market distortions into account by estimating economic prices for project outputs and inputs, The economic analysis of project uses these economic prices to determine whether the reallocation of resources brought about by a project creates a net gain or a net loss. ‘The key to this approach is that there is always an alternative use for the resources required for public sector projects, namely, that those resources could be used to pursue other activities in the private sector, 13 Sustainable Development ‘The natural resource base of the Philippines has long been the source of raw material inputs for investment projects. On the other hand, the environment — rivers, lakes, oceans, unused land, and the atmosphere — has often been the dumping ground for the unwanted by-products of economic activity. This type of development strategy is clearly unsustainable over the long run, ‘There is a growing concem in the Philippines and elsewhere about the threat to the well-being of ‘future generations, and more immediately, about whether environmental degradation i likely to impede investment by either putting the supply of natural resources in jeopardy or posing too great a health risk to both local and global populations. It is now recognized that damage to environment caused uring the process of economic and social development is a cost to society and must be accounted for while evaluating investments. There are three different concepts of sustainable development: the economic, ecological, and socio-cultural approaches.’ The economic approach aims to maximize the flow of income while maintaining the stock of capital (which ideally includes physical assets, human and natural resources and the environment). The ecological approach focuses on the sustainability of biological ecosystems that are critical to the maintenance of life. Emphasis is placed on biological diversity and the adaptability of ecosystems to respond to any changes. The socio-cultural approach on the other hand broadens the concept of ecosystems to include social and cultural systems. Issues that arise encompass intra- {generational equity (poverty, tribal rights, community stability and cohesion) and intergenerational equity (well-being of future generations who are unrepresented in today's decision-making). The last ‘wo approaches place more weight on the resilience of systems in being able to adapt to changes on a self-sustaining basis, See Munasinghe, Environmental Economics and Sustainable Development, 1993, p3, for details ofthese thee approaches. (Cuaprer 1.” Paosecr Hivatuation OMECrIVESAs would be evident from the following, the methodology adopted in this manual endeavors to capture the spirit of the approaches outlined above. a) Wherever possible, environmental externalities should be monetized and included in the ‘economic analysis of a project, The important issue is to ensure that non-renewable resources are priced at their marginal resource cost, which recognizes that more expensive resources may have to be accessed as resource utilization increases. b) The over-exploitation of renewable resources is referred to under the heading of common property resource externalities. ) Although this Manual does not adopt a socio-cultural approach to sustainable development, it recognizes the importance of consultation with community groups and other stakeholders in a project. 14 Social Objectives In broad terms, the proposed project should be responsive to the national objectives of poverty alleviation, employment generation and income redistribution.’ These issues fall under the heading of ‘equity considerations and are generally addressed using economic or employment impact analysis. For example, a project’s impact on creation of employment and earings opportunities is not an additional benefit from the project unless those affected are clearly made better off because of the project. ‘This manual, however, adopts a new approach to social objectives of income redistribution and poverty alleviation. First, the distributional analysis helps determine which groups in society are likely to be the main winners and losers from a project. Second, poverty concerns are addressed with a basic needs analysis of the project's impacts. 1.4.1 Distributional Analysis Although itis not realistic to expect that every individual project will cause a significant change in the distribution of income, itis necessary to identify winners and losers and quantify the extent of the gains and losses (o specific groups of stakeholders in the project. This is achieved through the distributional analysis of a project that is conducted from the perspective of each of the major parties affected - consumers, workers, owners of productive resources, owners of natural resources, taxpayers, etc. Where possible, the various groups are segmented by income in order to determine how much of the gain to consumers goes to low-income consumers or how much of the additional employment income goes to low-skilled workers. ‘The distributional analysis is important to decision-makers as it allows them to estimate the impact of particular policies or projects on segments of society and to recognize groups that would be net beneficiaries or net losers. Even though it will not provide a detailed accounting of how the overall income distribution is changed as a result of a project, it helps ensure that a project will not 7 Tavestinent Coordination Committee (CC) “Project Evaluation Procedures and Guidelines.” Gusren 1." Browser Evatvanion OwsecrnvesVouvu 2. place any undue burden on a specific group. If it does, then appropriate compensation may have to be estimated and a mechanism found to determine payment. The distributional or stakeholder’s analysis is discussed in Volume 1. 1.4.2 Meeting the Basic Needs of the Most Needy One of the developmental goals of the Philippine government is to meet the minimum basic needs (MBN) of the most needy. These basic needs mainly consist ofthe fundamental necessities of food and nutrition, health, basic education, water and sanitation. In terms of project evaluation, an emerging approach to integrating basic need concerns parallels the overall approach to poverty alleviation. This is the concept of a basic needs externality introduced by Professor Harberger.* ‘The essence of this approach is that a positive externality is associated with the improvement in the extent to which basic needs of the most needy are met. The externality is enjoyed by donor citizens (e.g., taxpayers) whose altruism is satisfied. This is like a public good and one donor's gratification does not preclude that of another. Services that satisfy basic needs are usually delivered in kind,” as opposed to an income transfer. Including a basic needs externality in project evaluation is equivalent to saying that society may be willing to tolerate a limited excess of economic costs over economic benefits only if the project's ‘outputs will contribute to the fulfillment of some basic needs. Projects having a bearing on basic needs may be viewed more favorably than those that lack this characteristic. ‘Thus, while the distributive analysis secks to allocate the net benefits generated by the project among the various stakeholders, the basic needs analysis further helps focus on the project’s contribution to the well-being of the most needy. Basic needs refer io the most essential needs of people such as nation, health care, education, and housing, The core of povery alleviation programs followed by most developing countries serves these sectors, and therefore the projects catering to those needs are more attractive to society. The concept of basic needs externality is duc to AC. Harberper, “Basic Needs Versus Distributional Weighs in Cost-Benefit Analysis,” in Economic Development and Cultural Change, 1984, Cniarran 3.” Provect Bvaucation OnvecrvesVou 2, Apvanceo Manuat on Proiger EVALUATION Cuapter 2 Provect EvaLuation CRITERIA This chapter covers the details of the various indicators used in project evaluation. ‘The financial attractiveness of a project is determined by the net present value (NPV) of its incremental net cashflows and the economic desirability is measured by the NPV of its incremental net economic benefits. The NPV criterion is widely accepted by accountants, financial analysts, and economists as the only one that yields correct project choices in all circumstances. However, some private investors have frequently relied upon other criteria such as a project's intemal rate of return (IRR) or a benefit-cost ratio, and others have used pay-back period criterion. ‘The strengths and weaknesses of these criteria are examined in this chapter in order to demonstrate why the NPV criterion is the most reliable. This chapter also addresses the topic of optimizing a project's NPV. Itis, generally speaking, most desirable to have a project’s NPV of incremental net economic benefits as large as possible. A number of decisions have to be made about a project that can affect the magnitude of its NPV, such as when it should start, how large the scale of investment should be, and how long a life the project should have. 2d The Net Present Value (NPV) Criterion ‘The NPV is the algebraic sum of the present values of the incremental expected positive and negative net cashflows over a project’s anticipated lifetime. If this sum is equal to zero, then investors ‘can expect to recover their incremental investment and earn a rate of retum on theit capital equal to the private discount rate used to compute the present values.' But if the private discount rate is ‘based on the market cost of capital for a project of equivalent risk, as it should be, then investors ‘would not be further ahead with a zero NPV project than they would have been if they had left the funds in the capital market. Investors are not worse off; they are just not better off. An NPV ‘greater than zero means that investors can expect not only to recover their capital investment and to eam a rate of return equal to the discount rate, but also to receive an addition to their real net worth equal to the positive amount of the NPV. In other words, a positive-NPV project outperforms the capital market and makes investors better off. Finally, if the NPV is less than zero, then investors cannot expect to earn a rate of return equal to the discount rate, nor recover their invested capital Hence, theirreal net worth is expected to decrease. Only projects with positive NPVs are going to ‘be beneficial and therefore attractive to private investors. They are unlikely to pursue a project with a negative NPV unless there are strategic reasons or they receive financial assistance. The recovery of the invested capital is anticipated NPV > 0 because the incremental capital expenditures are included inthe intial negative net cashflows. Gnarren 2.” Phosecr Evatuanion Carrenia‘Vowne 2. Apvancen MauaL ox Prosecr EvaLuarton The formula for computing the NPV of expected incremental net cashflows over n time periods with an annual discounting is nev = & t=0 (tr)! ‘where the incremental net cashflows (C)) could be negative, zero or positive, and r is the discount rate equal to the cost of capital and the sigma sign (5) is symbol for summation. It is today’s cost of capital that matters because that is what it either costs to raise the funds or is being forgone as a result of using available funds for a project rather than putting them to work in the capital market. The NPV formula can be written out in its component present values of the annual net cashflows, as follows G, c c, NPVCH Ee * Cran to Crap ‘The net present value criterion can be stated in the form of a set of decision rules. Decision Rule 1: Do not accept any project ifit generates a negative NPV when di discount rate equal to the opportunity cost of the funds. counted by a Deci mn Rule 2: ‘To maximize net worth, choose from among the various projects of scenarios of projects, the one with the highest NPV. When there is no budget constraint and ‘hen a choice must be made between two or more mutually exclusive projects, e.g, projects being considered for the same building site, then investors who seek to maximize net worth should select the project with the highest NPV. Decision Rule 3: If investment is subject to a budget constraint, then choose the package of projects that maximizes the NPV of the fixed budget. ‘The magnitude of the discount rate obviously plays an important role in the calculation of the NPV. Note that altemative and mutually exclusive projects should have the same length of life if they are to be compared, Also, Rule 3 is stated in terms of the absolute value of the NPV, not in terms of the NPV per peso of investment. Consider two projects, A and B, that are mutually exclusive for technical reasons and have the following characteristics: Project A: NPV of project A= PhP700,000. Present value of capital expenditure = PhP4,000,000. Project B: NPV of project B = PhP600,000, Present value of capital expenditure = PhP1,500,000.‘Vownte 2. AbvaNce Manual, on Paovect EVALUATION According to Rule 3, Project A with an overall NPV of PhP 700,000 should be chosen because it has the higher NPV, even though the NPV per peso of investment is higher for Project B (0.4) than for Project A (0.175). ‘The reason for choosing Project A is that even though it requires an incremental investment of PhP2,500,000, it yields an incremental gain in NPV of PhP 100,000 over and above a rate of return equal to the discount rate on the incremental investment. By choosing Project B, an investor would have a NPV of PhP600,000 and any additional funds are assumed to be invested in the capital market where they would have a zero NPV. Thus, by choosing Project A, an investor would be PhP100,000 better off, and Project A is the preferted choice. The financial attractiveness of a project to private equity investors is measured by the NPV of the incremental expected net cashflows to equity capital. The NPV is computed by using a private discount rate equal to the required rate of return to equity capital for projects of similar risk. This required rate of return should reflect the risk associated with the operating and financial leverage of 1 project as well as the risk due to uncertainty. Note that even though the NPV of the incremental net cashflows might be negative and a project would not appear attractive to private investors, it may create benefits for others in the form of economic externalities that should be captured in an economic analysis. [economic benefits are sufficiently large to outweigh the economic costs, then the government — on the grounds of improving economic efficiency — would have valid reason to offer the private investors some financial assistance to make the project more attractive to them. Figure 2-1 ‘Time Profiles of the Incremental Net Cashflows for Various Types of Projects Incremental Net Incremental Net Incremental Net Cashflow (a) Cashfiow (b) Cashflow (c) Tire Tire Tire Investment projects can exhibit different time profiles of the expected incremental net cashflow (cither to total or equity capital) over a project's life. For example, Figure 2-1 shows time profiles for three types of investment projects, namely: a) The investment expenditures initially cause the net cashflow to be negative, but once the expenditure is incurred, the rest of the net cashflows are expected to be positive over the project's life.Vout 2. Avancen Manual, ox Provact EvaLuation b). This profile is slightly different because after a few years of operations, the replacement of some of the project’s machinery and equipment causes the net cashflow to become temporarily. negative. ©) The last profile also tums negative, but this is due to a major expenditure at the end ofa project, e.g,, environmental regulations require a strip-mining site to be restored to its original condition. The criterion used to appraise investment projects must be applicable to any time profile of net cashflows, Unlike other possible criteria, the net present value criterion is the only one that meets this requirement. Although the NPV ctiterion is used by large companies and by the Philippine govemment, alternative criteria are also being used. Each alternative has serious drawbacks compared to the NPV criterion and is therefore judged not only as less reliable but potentially misleading. When two or more criteria are used to appraise a project, itis always possible that different conclusions are found and wrong decisions could be made. A government project analyst should be familiar with the shortcomings of these alternative criteria. Representatives of a government-owned and controlled corporation (GOCC) or a private company can often be adamant about the efficacy of their criteria as basis for investment decisions. Although these financial managers should not be told how to make decisions, a government project analyst should nevertheless employ the NPV criterion in assessing the gains that private investors stand to enjoy by undertaking a certain project. 2.2 Internal Rate of Return (IRR) Criterion By definition, the IRR is the discount rate (p) that sets the NPV = 0 in the following equation: > —S «1-0 m+ py where C, = the incremental net cashflow in year j to total, or equity capital , 1 = the initial investment , P = the IRR. We have to solve for p . This definition is consistent with the meaning of a zero NPV as explained in the previous section, namely that investors recover their invested capital and ear a rate of retum equal to the discount rate, Which is the IRR. The IRR can be stated in the form of a set of decision rules. Deci in Rule 1: Do not accept any project unless its IRR is greater than the opportunity cost of funds. (Accept project if p> r, the opportunity cost of capital; otherwise, reject). ‘The opportunity cost of capital is measured by the cost of funds or expected rate of return offered by other assets equivalent in risk to the project being evaluated. ‘naeTER 2.” Provecr EvalvaTion CRrvENiaVou 2, Abvaxcep Maxual ox Provuct Evawwarion Decision Rule 2: When a choice must be made between two or more mutually exclusive project, then investors should select the project with the higher or highest IRR Table 2-1 lists the problems with the IRR criterion, We shall discuss them in tur. Table 2-1 Problems with the IRR Criterion ‘The IRR may not be unique. There could be multiple IRs or no IRR. “Mutually exclusive projects, e.g., projects of different scale are ordered wrongly. | TRRs are not additive. - - IRR generally favors projects with shorter lives. IRR is independent of the timing of a project (i. is sensitive to timing, vlsleipl= " project's start date), whereas Te Problem No. 1: The IRR may not be unique, there could be multiple IRRs, of the IRR may noteven exist. ‘The IRRis, strictly speaking, the root of a mathematical equation. The equation is based on the time profile ofthe incremental net cashflows like those in Figure 2-1, Ifthe time profile crosses the horizontal axis from negative to positive only once as in Figure 2-1(a), then the root or IRR will exist, but it may not ‘be positive, However, if the time profile crosses the axis more than once as in Figure 2-1(b) and 2-1(©), then there may be more than one root or there may be no real roots but only imaginary roots. Although this ‘may sound like more of a theoretical concem, it is certainly disconcerting to know that an investment decision criterion may not have a solution. Consider an example like Project B that has the following net cashflow in thousands of constant pesos: ‘Time Profile of Net Cashflow for Project B guerre oe canadaunnacaa | a pa) ae Tw | ale J“ _| Net Cashflows of B in PhP, thousands | -20 Project B has IRRs of approximately 0 percent, 100 percent, and 200 percent (i.e. these roots ‘ill solve the IRR equation and set the NPV equal to ero). Let us assume that the private opportunity cost of capital was 6 percent. Should we accept this project? Let us further assume that we are unaware of the foregoing discussion about multiple IRRs and that we have calculated only the IRR of 100 percent. A project with an IRR of 100 percent sounds very attractive, especially compared to the relatively low 6 percent cost of capital, Should we approve the project? Cuabten 2.” Provect EvasuxTion Crurenia