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CHAPTER 3

APPRAISAL OF PPP PROJECTS

3.1 Introduction Although, we are familiar with tools such as Gantt chart, PERT, CPM, IRR, NPV and others associated with project management. Yet when it comes to real project scenario, we find practical problems which could bring deviations. This is not to suggest that the tools and techniques are inadequate, Project appraisal and evaluation are often referred to together as project assessment. Project appraisal is concerned with assessing, in advance, whether a project is worthwhile and therefore if it should be proceeded with. The process of project evaluation is concerned with assessing, in a retrospective sense, the performance of a project after it has been implemented and completed. Such a process of policy assessment occupies a central place in public policy and management. Many of the issues of public policy and management are about resource allocation, the trade-offs between different policy measures and the impacts of those policy measures on the economy and on society. Management in the public sector is subject to budgetary constraints and often to political pressures; project appraisal techniques may help in the decision process and obtain a more efficient allocation of resources. Gittinger (1982) defines a ‘project’ as ... an investment activity upon which resources – costs – are expended to create capital assets that will produce benefits over an extended period of time and which logically lends itself to planning, financing, and implementing as a Unit. A specific activity, with specific starting point and specific ending point, intended to accomplish a specific objective. The smallest operational element prepared and implemented as a separate entity in a national plan or program. Generally unique in that it is not a segment of an ongoing program, although it may be a ‘time slice’– a portion lasting several years – of a long-term program. The basic purpose of systematic appraisal is to achieve better spending decisions for capital and current expenditure on schemes, projects and programmes. An understanding of discounting and Net Present Value (NPV) calculations is fundamental to proper appraisal of projects and programmes. A good understanding of Cost Benefit Analysis (CBA), Internal Rate of Return (IRR), Multi Criteria Analysis (MCA) and Cost Effectiveness Analysis (CEA) is also essential for economic appraisal purposes. 3.1.1 Technical Appraisal Determines whether the technical parameters are soundly conceived, realistic and technically feasible. Technical feasibility analysis is the systematic gathering and analysis of the data pertaining to the technical inputs required and formation of conclusion there from. The availability of the raw materials, equipment, hard/software, power, sanitary and sewerage services, transportation facility, skilled man power, engineering facilities, maintenance, local people etc., depending on the type of project are coming under technical analysis. This feasibility analysis is very important since its significance lies in planning the exercises, documentation process, risk minimization process and to get approval. Checklist

- Physical scale - Technology used & Type of equipments & Suitability conditions - How realistic is the implementation schedule - Labour intensive method or others

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- Cost estimates of Engineering Data - Escalation are taken care of or not - Procurement arrangement - Cost of operation & Maintenance - Necessary raw material & Inputs - Potential impact of project on human & physical Environment -

3.1.2 Financial Appraisal To determine whether the financial costs and returns are properly estimated and whether the project is financially viable. Following minimum details are determined in the financial appraisal;

1. Total Cost 2. O & M Expenditure 3. Opportunity costs 4. Other costs 5. Returns on Investment over project life 6. NPV 7. CBR 8. IRR

3.1.3 Institutional Appraisal To determine whether the implementing agencies as identified in the report are capable for effective implementation, monitoring, and evaluation of the scheme. Managerial competence, integrity, knowledge of the project, the promoters should have the knowledge and ability to plan, implement and operate the entire project effectively. The past record of the promoters is to be appraised to clarify their ability in handling the projects. Checklist

• Whether the entity is properly organised do the job • Strength to use capability and take initiatives to reach the objectives • Openness to new ideas and willingness to adopt long term approach to extend over

several projects •

3.1.4 Commercial Appraisal The demand and scope of the project among the beneficiaries, customer friendly process and preferences, future demand of the supply, effectiveness of the selling arrangement, latest information availability on all areas, government control measures, etc. The appraisal involves the assessment of the current demand/market scenario, which enables the project to get adequate demand. Estimation, distribution and advertisement scenario also to be here considered into. 3.1.5 Environmental Appraisal To see any detrimental environmental impacts and how to minimise the impacts. Environmental appraisal concerns with the impact of environment on the project. The factors include the water, air, land, sound, geographical location etc.

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3.1.6 Economic Appraisal How far the project contributes to the development of the sector, industrial development, social development, maximizing the growth of employment, etc. are kept in view while evaluating the economic feasibility of the project. 3.1.7 Legal Appraisal To determine whether the project satisfies the legal issues related to land acquisition, title deed, environmental clearance etc. 3.2.0 Analytical methods The recommended analytical methods for appraisal are generally discounted cash flow techniques which take into account the time value of money. People generally prefer to receive benefits as early as possible while paying costs as late as possible. Costs and benefits occur at different points in the life of the project so the valuation of costs and benefits must take into account the time at which they occur. This concept of time preference is fundamental to proper appraisal and so it is necessary to calculate the pre Net Present Value Method (NPV) 3.2.1 Steps in NPV Calculation Step 1. Estimate the cash inflows and outflows on a year-to-year basis. Step 2. Work out the net cash flows for individual years. Step 3. Find out for individual years the discount value of 1 at the given discount rate Step 4. Multiply the net cash flows for each year by the corresponding discount factor. Step 5. Add up the present values In the NPV method, the revenues and costs of a project are estimated and then are discounted and compared with the initial investment. The preferred option is that with the highest positive net present value. Projects with negative NPV values should be rejected because the present value of the stream of benefits is insufficient to recover the cost of the project. Compared to other investment appraisal techniques such as the IRR and the discounted payback period, the NPV is viewed as the most reliable technique to support investment appraisal decisions. There are some disadvantages with the NPV approach. If there are several independent and mutually exclusive projects, the NPV method will rank projects in order of descending NPV values. However, a smaller project with a lower NPV may be more attractive due to a higher ratio of discounted benefits to costs (see BCR below), particularly if there affordability constraints. Using different evaluation techniques for the same basic data may yield conflicting conclusions. In choosing between options A and B, the NPV method may suggest that option A is preferable, while the IRR method may suggest that option B is preferable. However in such cases, the results indicated by the NPV method are more reliable. The NPV method should be always be used where money values over time need to be appraised. Nevertheless, the other techniques also yield useful additional information and may be worth using. The key determinants of the NPV calculation are the appraisal horizon, the discount rate and the accuracy of estimates for costs and benefits. 3.2.2 Discount rate The discount rate is a concept related to the NPV method. The discount rate is used to convert costs and benefits to present values to reflect the principle of time preference. The calculation of the discount rate can be based on a number of approaches including, among others:

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� The social rate of time preference � The opportunity cost of capital � Weighted average method

The same basic discount rate (usually called the test discount rate or TDR) should be used in all cost-benefit and cost-effectiveness analyses of public sector projects. The current recommended TDR is 4%. However, given the recent changes in economic circumstances, the current discount rate needs to be updated. This task will be undertaken by the CEEU and the revised discount rate will be published in section E of the code –Reference and Parameter Values. However, if a commercial State Sponsored Body is discounting projected cash flows for commercial projects, the cost of capital should be used or even a project-specific rate. 3.2.3 Internal Rate of Return (IRR) The IRR is the discount rate which, when applied to net revenues of a project sets them equal to the initial investment. The preferred option is that with the IRR greatest in excess of a specified rate of return. An IRR of 10% means that with a discount rate of 10%, the project breaks even. The IRR approach is usually associated with a hurdle cost of capital/discount rate, against which the IRR is compared. The hurdle rate corresponds to the opportunity cost of capital. In the case of public projects, the hurdle rate is the TDR. If the IRR exceeds the hurdle rate, the project is accepted. There are disadvantages associated with the IRR as a performance indicator. It is not suitable for the ranking of competing projects. It is possible for two projects to have the same IRR but have different NPV values due to differences in the timing of costs and benefits. In addition, applying different appraisal techniques to the same basic data may yield contradictory conclusions. The calculation of the internal rate of return involves the following steps. Step 1. Estimate the cash inflows and cash outflows on a year-to-year basis Step 2. Work out the net cash flows for individual years. Step 3. Select any random discount rate and compute the net present values. Step 4. If the NPV thus arrived at is positive, then select a higher discount rate at which the

NPV may come close to zero. If, however, the NPV is negative, then select a lower discount rate at which the NPV may come close to zero.

Step 5. Repeat the exercise until a discount rate that reduces the net present values to zero is found 3.2.4 Benefit / Cost ratio (BCR) The BCR is the discounted net revenues divided by the initial investment. The preferred option is that with the ratio greatest in excess of 1. In any event, a project with a benefit cost ratio of less than one should generally not proceed. The advantage of this method is its simplicity. Using the BCR to rank projects can lead to suboptimal decisions as a project with a slightly higher BCR ratio will be selected over a project with a lower BCR even though the latter project has the capacity to generate much greater economic benefits because it has a higher NPV value and involves greater scale.

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Benefit-Cost Ratio The benefit-cost ratio is a ratio calculated by dividing the sum of discounted benefits by discounted costs. Steps for calculating the benefit-cost ratio are: Benefit – Cost Ratio = Sum of Discounted Benefits Sum of Discounted Costs Step 1. Estimate the cash inflows and outflows on a year-to-year basis Step 2. Find out for individual years the discount value of 1 at the given discount rate. Step 3. Multiply the cash inflows and cash outflows for each year by the corresponding

discount factor. Step 4 Add up the discounted values of cash inflows and outflows separately. Step 5. Divide the discounted values of cash inflows by cash outflows to obtain the benefit-cost ratio. 3.5 Sensitivity analysis An important feature of a comprehensive CBA is the inclusion of a risk assessment. The use of sensitivity analysis allows users of the CBA methodology to challenge the robustness of the results to changes in the assumptions made (i.e. discount rate, time horizon, estimated value of costs and benefits, etc). In doing so, it is possible to identify those parameters and assumptions to which the outcome of the analysis is most sensitive and therefore, allows the user to determine which assumptions and parameters may need to be re-examined and clarified. Sensitivity analysis is the process of establishing the outcomes of the cost benefit analysis which is sensitive to the assumed values used in the analysis. This form of analysis should also be part of the appraisal for large projects. If an option is very sensitive to variations in a particular variable (e.g. passenger demand), then it should probably not be undertaken. If the relative merits of options change with the assumed values of variables, those values should be examined to see whether they can be made more reliable. It can be useful to attach probabilities to a range of values to help pick the best option. Sensitivity analysis requires a degree of exploratory analysis to ascertain the most sensitive variables and should lead to a risk management strategy involving risk mitigation measures to ensure the most pessimistic values for key variables do not materialise or can be managed appropriately if they do materialise. It is important to take into account the level of disaggregation of project inputs and benefits – sensitivity analysis based on a mix of highly aggregated and disaggregated variables may be misleading. 3.6 Scenario analysis The scenario analysis technique is related to sensitivity analysis. Whereas the sensitivity analysis is based on a variable by variable approach, scenario analysis recognises that the various factors impacting upon the stream of costs and benefits are inter-independent. In other words, this approach assumes that that altering individual variables whilst holding the remainder constant is unrealistic (i.e. for a tourism project, it is unlikely that ticket sales and café-souvenir sales are independent). Rather, scenario analysis uses a range of scenarios (or

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variations on the option under examination) where all of the various factors can be reviewed and adjusted within a consistent framework. A number of scenarios are formulated – best case, worst case, etc – and for each scenario identified, a range of potential values is assigned for each cost and benefit variable. When formulating these scenarios, it is important that appropriate consideration is given to the sources of uncertainty about the future (i.e. technical, political, etc). Once the values within each scenario have been reviewed, the NPV of each scenario can then be recalculated. 3.6.1 Using Excel to Determine NPV and IRR Excel contains a number of built-in financial functions. Two of these, NPV and IRR, help you calculate the value of a proposed capital budgeting investment. The time value of money calculations are integrated with NPV and IRR in Excel. 3.6.2 Setting up the Spreadsheet with the Cash Flows We will consider the following example to walk through the process of using Excel for capital budgeting problems: Spec, Inc. is considering the purchase of a machine that costs 60,000 with an estimated salvage value of 12,000. Operating cash flows are estimated to be 15,000 in year 1, 18,000 in year 2 and 21,000 in year 3. The company's cost of capital is 6.22% and its required rate of return is 8.50%. Enter the cash flows in an Excel worksheet in the following format:

Year 0 Year 1 Year 2 Year 3

Operating Cash Flows

15000 18000 21000

Investing Cash Flows 60000

12000

Total Cash Flows 60000 15000 18000 33000

The format of the cash flows in Excel looks a little different than those shown on a time line. Year 0 is the date the machine is anticipated to be purchased. It is also the beginning of the machine's useful life, the beginning of year 1, because it will start producing income at that point. There is exactly one year of time between year 0 and year 1, and between each of the other years listed. Recall in an earlier chapter that the operating cash flows are expected to occur at the end of the particular year of operations. While four columns appear with amounts in them, the time span is for the useful life, a period of three years. While you can directly type the cash flow amounts into the NPV and IRR wizards, you will find the format above streamlines the process when you need to calculate both NPV and IRR for the same data. A table such as the one above allows to enter the cash flow amounts only once and then cell reference the amounts in the wizard. 3.6.3 NPV in Excel Open a blank worksheet in Excel. From Excel's menu, choose Formulas, then choose Insert Function to display the Function Wizard. Alternatively, you can click the fx icon from the formula bar.2.

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The Insert Function wizard will appear as shown below. Type the label, NPV in the search field. Select NPV from the list displayed.

Click OK to display the Function Arguments Wizard. The wizard displays three fields as shown in the graphic below--rate, value1, and value2. As you move your cell pointer from field to field, the description of the data to be entered into each field appears in the gray area below the fields

. Place the cell pointer in the Rate field and type the required rate of return in a percentage or decimal format. For example, 8.25% should be entered as 8.50% (including the decimal sign) or as a decimal, 0.085. Note this is a different format than the input in the BAII plus calculator.

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To cell reference to the respective cash flows, place the cell pointer in the Value1 field. Hold down the left mouse button, and select cells C6 to E6. It much quicker to cell reference the range of cells which contains the cash flows. One word of caution here: Do NOT cell reference the initial cost (B6) into the wizard. Money paid out today has no interest cost, so we do not discount the year zero cash flow.

Press OK and Excel will display the amount of the present value of all the cash inflows as 55,233.The NPV formula is displayed in the formula bar as: =NPV(0.085,C6:E6) Only the cash flows which occur at the ends of years 1, 2, and 3 are calculated in the function. Because no discounting is applied to money paid out at year 0, we can simply combine the initial cash outflow with the present value of the future cash flows. To calculate the net present value, you must subtract the 60,000 acquisition cost. Because the 60,000 is displayed in cell B6 as a negative (as a cash outflow), you must add the negative amount. To do this, click your cell pointer at the end of the NPV formula in the formula bar, and type + and the cell reference of the year 0 cash flow amount. This will add the negative cash outflow that appears in cell A2 to the positive present value amount of 55.233. =NPV(0.085,C6:E6)+B6 The NPV is (4,767). Common practice is to display amounts to the nearest whole dollar (unless the amount is a unit amount or percentage which require two decimals.) Because the NPV is a negative amount, it tells you that the investment earns less than the company's required rate of return. 3.6.4 IRR in Excel Use the same worksheet and the same cash flows as you did for NPV. Click Insert, then choose Function to display the Function Wizard. Type IRR in the search field. Select IRR from the list displayed. Click OK to display the Wizard. The Wizard displays 2 fields--Values and Guess.2.

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You will cell reference ALL the cash flows, including the cost from the Values field by holding down the left mouse button and selecting cells B6 to E6. Leave the Guess field blank. For most capital budgeting approaches, you may omit the Guess field. When Excel calculates IRR, it does so by trial and error beginning with 10 percent. If trial and error runs more than about 40 seconds and Excel has not found the correct return, it will time out. A 'guess' would give Excel a different percentage to begin with to avoid time outs. You will not see any situations which create time outs in this course. Click OK and Excel displays the answer as 4.31%. Be sure to format the cell as a percentage with two decimal places. If your answer appears as 0, you likely have a cell formatting error. Since 4.31% is less than the company's required rate of return of 10.3%, you should reject the proposed investment since it will earn less than the company desires as its minimum return.

Remember that it is always better to get money as soon as possible because you can invest it and earn interest on it. 3.6.5 Cost assessment A detailed estimate of the capital and operating and maintenance costs (either both or one of these depending on the type of project) needs to be carried out.

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The capital (Capex) cost assessment will be based on the components of the preliminary technical design. The Advisor would base the estimate on prevailing market costs, recent costs for similar work and materials, and their own estimates. Detailed operating and maintenance (Opex) cost estimates would be based on a schedule of activities over the lifetime of the project assets. The type and timing of maintenance will vary depending on the type of project (eg, A water sector project would have different maintenance requirements to a roads project). Operating costs would include an estimate of labour requirements. 3.6.6 Financial viability and PPP due diligence In this stage a quantitative analysis of the financial feasibility of the project using the most promising PPP modal option or options is carried out. This stage also allows an assessment of likely VGF or other public-sector financial assistance requirements (eg IIFCL or state-level PPP finance vehicles). This financial analysis is an important part of the “due diligence” that should be carried out on the PPP project. Although the entire PPP process should be conducted with due diligence it is worth emphasising it at this critical stage. The financial analysis will use information gained from the demand forecasts, technical feasibility, and cost estimates, and will reflect the PPP mode that has been chosen. It should include demand and cost scenarios. A typical structure and information flows in a financial model is shown in the figure and described more below.

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3.6.7 Typical structure and flows in a financial model

A detailed financial analysis model would usually need to be tailored to the particular characteristics of the project. This would be done by transaction advisors unless the Sponsor has this specialist expertise in-house. The inputs to the detailed financial analysis would include the following:

• The life-cycle costs of the project and their timing. These include the estimated capital costs and operating and maintenance (O&M) costs identified in the cost assessment and a depreciation schedule for physical assets

• Revenue options and the associated forecast revenue stream. This will include tariffs (where user-charges are possible), and secondary revenue sources from the project.

• Forecast demand including scenario ranges from the feasibility study • Assumed capital structure (debt - equity mix) of private sector investment vehicle • Debt and repayment schedule • The discount rates for the public sector and private investor consistent with the capital

structure and allocation of project risks • Project specifications (investment timing, lifetime etc)

Sensitivity ranges on assumptions, designed to encourage a careful consideration of probable outcomes and reduce optimism bias. The outputs of the model would include:

• Expected returns from the project illustrated by the NPV, IRR (see below).

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• An assessment of subsidy or viability gap funding requirements where there is a viability gap between the revenue requirement and the revenues that can be raised from users

• Summary financial information including ratio analysis Together these outputs will provide a quantitative assessment of the financial viability of the PPP. The scenario analysis may include different risk allocations and even variations in the PPP mode. This means there can be feedback between this analysis and the risk allocation. 3.6.8 Cost of capital An especially important input to present value analysis is the ‘discount rate’ (or required rate of return) to use. Separate analyses should be applied using different discount rates:.

• In the first analysis, a realistic assessment of commercial discount rate should be used. This will determine what a commercial investor would require in order to invest.

• The second analysis would use the government’s own cost of funds. This may be lower than that applied for private sector investors, particularly at the Central level. However, it is not always the case that the public sector is able to borrow more cheaply than the private sector. State or local governments in particular may face higher rates depending on their credit rating. The appropriate rate should be reflected in the analysis. Click here for a brief explanation of discount rates. The toolkit's PPP Financial Viability Indicator model can be used to carry out a more simplified analysis of the key questions of financial viability and to test these using ‘what-if?’ scenarios. 3.6.9 Economic feasibility A feasibility study may also include an economic analysis of the project. The purpose of economic analysis is to determine whether there is an economic case for the investment decision. This assessment goes beyond the items typically included in a financial analysis. Economic feasibility is interested in:

• the economic benefits from the project • the economic costs of the project • the balance of these expressed in present value terms (the net economic benefit)

Economic costs and benefits are not always the same as financial cost and benefits. Economic analysis includes project impacts that do not have a market price and positive and negative impacts that are experienced by people who are not the direct users of the services. It is in this way that economic analysis casts a broader net than a financial assessment. Accounting tools such as depreciation and capital charges should not be included in an economic analysis. 3.6.10 Benefits and costs included in an economic assessment include:

• Market valuations of the inputs (land, materials, labour etc) to the project, adjusted for any distortions in the market (such as taxes or subsidies)

• The valuation placed on the services by the users. ie, how much would users be willing to pay for the benefit they would receive from the service. This is not necessarily the same as what they would actually be charged

• Secondary or spill-over costs and benefits that have an impact beyond the project itself (sometimes called externalities), for example

o Impacts from the project on the broader economy o Valuations of non-market factors from the social and environmental assessment (social and

environmental externalities)

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The impacts that would need to be considered will vary depending on the nature of the project and the sector. For example, a highways, roads or public transport project will provide direct benefits to the users of the infrastructure or services provided, but will also provide benefits to other road users if congestion on existing roads is reduced. Another example of secondary economic impacts is flow-on effects to the efficiency of the economy as a result of improved infrastructure. Negative environmental externalities from a road project would include increased local pollution along the corridor. However, this should be assessed in the context of positive effects such as improved vehicle running efficiency due to eased congestion. The results of the market analysis and scope, technical, social and environmental feasibility, financial cost assessments, and risk analyses are all inputs to the economic feasibility. They should provide a set of scenarios (sensitivity ranges on the values assumed in the analysis) that can be tested as part of the economic feasibility in order to get an idea of potential variation in the outcome. Specialist advisors would usually be a part of the team engaged to carry out the feasibility. 3.7.0 Measurement of non-market benefits and costs Where some benefits and costs from the project do not have an observable monetary value (eg a market price) a full quantitative analysis would require a monetary value to be estimated. The advisor or analyst who is conducting the economic feasibility study would need to propose and justify the valuation. This should be based on a strong and defensible methodology as the valuation of non-monetary benefits and costs can be very subjective. 3.7.1 Comparison against the next-best alternative investment option Part of an economic case for a PPP investment will be an assessment of the next best alternative investment or expenditure to achieve a similar result. This is used as a benchmark for setting a minimum value of the output from the investment. Definition and valuation of the next best alternative must be proposed and justified by the analyst or advisor. Decision criteria: NPV and EIRR The final output of the economic feasibility assessment will include the Net Present Value (NPV) of the project’s economic costs and benefits. This captures the value today of the costs and benefits that occur over the life of the project. It has the benefit of summarising a lifetime of values into a single figure and allowing easy comparison of value between different projects. Comparisons of the NPVs of different projects are assessed using the same discount rate (required rate of return). An economic internal rate of return (EIRR) is commonly also calculated, which is a similar decision factor to the financial IRR. The EIRR indicates the rate of return at which the present value of the economic costs and benefits of the project are equal. In other words, it is the discount rate for which the net present value is zero. The EIRR should be compared with the socially required rate of return. Projects that are found to have an EIRR that is higher than the socially required rate of return would be said to be economic investments. These may then proceed for detailed analysis of their viability as PPPs. The NPV and EIRR give different sorts of information about a project. The NPV provides a decision criterion on whether the project should proceed at all (in general a project with a negative NPV should not be pursued) and also allows direct comparison of actual value between projects. On the other hand, the EIRR is better suited to being a decision

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criterion only. By allowing a project to be compared against a required rate of return it gives a yes or no answer about whether it is economic. However, the EIRR alone does not give enough information to say whether one project should be pursued ahead of another. This is a value comparison and the NPV should be used. 3.7.2 A Note on problems that can arise with the EIRR and IRR criteria Multiple IRRs are possible for a project whose net benefits change sign more than once over the payment stream. In this case the IRR loses its meaning. The IRR is also not the appropriate indicator for deciding between mutually exclusive projects. This is a situation in which only one of the alternatives can be chosen and once it is selected the other project is no longer possible (for example, if it is a choice between two projects that would use the same site). It is possible for one of the projects to have a higher IRR while the other project has a higher NPV. Since NPV is a measure of value (for a given rate of return) it is the appropriate decision criterion in this case. The higher NPV project should be selected over the higher IRR project. Comparable models To determine which procurement choice is best for a project, a comparative assessment has to be made between delivering the sae service (to the identical output specification) as a conventional public sector procurement or as a PPP. A risk–adjusted public sector comparator(PSC) model and PPP reference model must therefore be constructed for the chosen solution option. These provide costing of each procurement option in the form of a discounted cash flow model adjusted for risk. A PSC model is a costing of a project with specified outputs with the public sector as the supplier. Costs are based on recent, actual costs of a similar project, or best estimates. A PPP reference model is a costing, from first principles, of a project with the identical specified outputs with the private sector as supplier. Comparing the two models enables an institution to assess whether service delivery by the government or by a private party yields the best value for the institution. The three criteria are affordability, risk transfer and value for money. Risk Risk is inherent in every project. Conventional public sector procurement has tended not to take risk into account adequately, often resulting in unbudgeted cost overruns. In a PPP, the risks inherent in the project are managed and costed differently by the private party. The treatment of risk in the project is a key aspect of the value assessment. Affordability and Value for Money Affordability is whether the cost of the project over the whole project term can be accommodated in the institution’s budget, given its existing commitments. Value for money means that the provision of a institutional function by a private party results in a net benefits to the institution, defined in terms of cost, price, quality, quantity, or a risk transfer, or a combination of these. Value for money is a necessary condition for PPP procurement, but not a sufficient one. Affordability is the driving constraint in PPP projects.

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Demonstrating affordability As a preliminary analysis of affordability, the risk –adjusted PSC model is compared with the institutions budget. Then the risk-adjusted PPP reference model is compared with the institution’s budget. If the project is not affordable, the institution may modify the output specifications or may have no abandon the project. The value- for –money test The value for money test is only conducted as part of TA:II when actual private bids are submitted. But an initial indication of whether conventional public sector procurement or a PPP will provide value for money is a requirement for TA:I. The risk-adjusted PSC model provides the benchmark for value for money when compared with the PPP reference model in this feasibility study phase, and when compared with the private bids in the procurement phase.

3.7.3 Part 1: CONSTRUCT THE BASE PSC MODEL What is the base PSC model? The base PSC model represents the full costs to the institution of delivering the required service a according to the specified outputs via the preferred solution option using conventional public sector procurement. The base PSC costing includes all capital and operating costs associated with the project. The public sector does not usually cost these risks, but it is necessary to get this understanding of the full costs to government of the proposed project. Key Characteristics of the PSC model

• Expressed as the net present value (NPV) of a projected cash flow based on the appropriate discount rate for the public sector

• Based o the costs for the most recent, similar, public sector project, or a best estimate • Costs expressed as nominal costs • Depreciation not included, as it a cash flow modle.

The central functions of the PSC model

• Promotes full cost pricing at an early stage • Is a key management tool during the procurement process, assisting the institution to stay

focused on the output specification, costs and risk allocation • Is a reliable way of demonstrating the projects affordability • Provides an initial indication of value for money • Is a consistent benchmark and evaluation tool • Encourages bidding competition by creating confidence in the financial robustness and

integrity of the feasibility process • Is sufficiently robust that the service could be procured conventionally if, at any stage, the

PPP fails to show value for money 3.7.4 Construct the base PSC model Step 1: provide a technical definition of the project Step 2: calculate direct costs Step 3: calculate indirect costs

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Step 4: calculate any revenue Step 5: explain all assumptions used in the construction of the model Step 6: construct the base PSC model and describe its results Step 2: calculate direct costs Direct costs are those can allocate to a particular service. These costs must be based on the most recent public sector project to deliver similar infrastructure or services (including ay foreseeable efficiencies, for examples, regular life-cycle maintenance),or a best estimate where there is no recent comparable public sector project. If there is no comparable project in South Africa, draw on the experience of projects in similar environments in other countries. 3.7.5 Case Study: APPRAISAL OF A TOWN LEVEL WATER SUPPLY PROJECT Pricing and cost recovery in water supply projects has become almost unworkable for the small and medium towns due various reasons. Irregular supply, enormous maintenance and high energy costs, inadequate water treatment, poor recovery, inadequate pricing of water supply to consumers, provision of underground drainage, sewage treatment are some the intricate reasons for not providing minimum supply of water as per the normative standards. Water Supply project implemented by Tiruppur Area Development Corporation, JUSCO and a few city corporations have become sustainable and income generative. Increased efficiency and full cost recovery by billing, metering, technical designs, automation of metering, etc. would help. Billing system covering variable charges for economically weaker sections, commercial, high income groups etc., need to be adopted suitably. Appropriate service providers like SPV could be used. Therefore, a small example of how a town level water supply project can be remunerative even with minimum pricing is illustrated below; Minimum Data

1. PROJECT: Supply of Water to a residents of a town consisting of 10,000 houses 2. Capital Expenditure : Rs. 7 crores 3. Cost of Capital : 10% 4. Operations and maintenance Rs. 25 lakhs per annum 5. Average revenue from each house hold Rs. 150 per month or Rs1.8 crore/year 6. Life of the project: 10 years

With the above data available with us, we can now work out Net Present Values, Benefit Cost Ratio and IRR based on the incomes and expenditure over the period of 10 years as below 3.7.6 Analysis of Net Cost Benefit of the Water Supply Project

Years

Particulars 1 2 3 4 5 6 7 8 9 10 Total

Incremental Revenue (Rs in Crores)

1.8 1.8 1.8 1.8 1.8 1.8 1.8 1.8 1.8 1.8

Incremental cost (Rs in Crores)

0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25

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Net cash flow (Rs in Crores)

1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55

PVIF at 10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

PV of cash flows at 10%

1.41 1.28 1.16 1.06 0.96 0.87 0.80 0.72 0.66 0.60 9.62

PVIF at 20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162

PV of cash flows at 20%

1.29 1.08 0.90 0.75 0.62 0.52 0.43 0.36 0.30 0.25 6.5

BCR at 10%=9.62/7=1.37 IRR -10%+(20-10)X(9.62-7)/ (9.62-6.5) IRR-18.40% Return on investment=18.4%-10%= 8.4% 3.7.7 Project Appraisal Report The appraisal of a project would provide the project authorities the following information for taking decision;

I. Does it meet the immediate and long-term objectives? II. How does the project compare with other competing projects?

Project appraisal leads to overall assessment of the project’s chances for success based on the findings of the feasibility analysis. It seeks to establish what will occur, who will gain and lose, when the project’s impacts will occur and the efficiency of the project investments in relation to the benefits derived. The form of the project appraisal process depends on a variety of factors, such as the scale and complexity of the given project, the nature of the organization involved, the availability of professional staff, the importance attached to non-economic factors and so forth. A project appraisal report should cover the following topics.

1. Description of the project proposal and its objectives; 2. Description of the current baseline conditions. 3. Economic and financial appraisal 4. Socio-cultural assessment 5. Environmental assessment 6. Overall assessment of the project proposal (findings of the project appraisal process) 7. Conclusions and recommendations 8. Preliminary framework for project monitoring and evaluation.

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3.8.0 Appraisal of Projects in General

Appraisal -Technical Appraisal to determine whether the technical parameters are soundly conceived, realistic and technically feasible. -Financial Appraisal to determine whether the financial costs and returns are properly estimated and whether the project is financially viable -Institutional Appraisal to determine whether the implementing agencies are capable for effective implementation, monitoring, and evaluation of the scheme. -Environmental appraisal to see any detrimental environmental impacts and how to minimise the impacts.

Legal Appraisal -Legal documentation

Financial Appraisal 1. Loans/Grants 2. Own Sources 3. Subsidies 4. Capital investment 5. O&M investment 6. Cost-Benefit analysis 7. Cost Recovery Mechanism 8. Repayment of Loans

Technical Appraisal -Feasibility -Specifications -technology options -quality and durability -standards -designs etc

Social Appraisal (Social cost and benefits, target group

Project Execution -Tendering -contractor -Schedule -Target -Procurement of materials/equipment - performance - payments - likely hurdles - scope etc

Project Evaluation Documentation Project study Project performance

Monitoring and supervision -Progress reports -Site Inspection -Cost and Time Control -Deviations -Completion Reports

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3.8.1 Checklist :Financial Appraisal of a Infrastructure Development Project- Corrective Actions-Flow chart

Cost of Depreciation

Any other Costs

Financial Appraisal

Total Cost of the Project/Investment

O & M Costs

Remunerative Project Component

Total Costs

Benefits/Returns from Remunerative Projects

Premiums/ Deposits from renting/leasing of commercial shopping/ centres

Income from sale of Sites and services Project

Renting or Leasing of New Bus Stand/Park etc

Any other Incomes from the remunerative project

Incomes over the next 25 years

Cash Flow Analysis for 25 Years

Calculation of NPV/IRR/CBR- Decision to select the project

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3.8.2 TEMPLATE (Indicative) Project Appraisal

Sl No. Name of the Project

1

Need for the Project

2 project proposal and its objectives;

Proposal Objectives

3 Immediate and long-term benefits?

Immediate objectives Long term objectives

4 Description of the current baseline conditions. What would happen in the absence of project? Study Area/Location Environmental Impact Beneficiaries Social costs Legal issues Demand Other Constraints Favourable conditions Etc.

5 Project comparison with other competing projects?

Eg. Alternative options: based on feasibility analysis

6 Economic and financial appraisal • Total Cost • O& M Expenditure • Opportunity costs • Other costs • Returns on Investment

over project life • NPV • CBR • IRR • Medium and Long

term benefits • Financial viability • Recovery of costs

7 Institutional Appraisal Eg. Capability in terms of expertise, personnel, skills, worth, past experience etc.,

8 Legal Assessment Eg. Land, title deed, clearances, NOC etc.

9 Technical appraisal 1. Technology used & Type of equipments & Suitability conditions

2. Hardware, software, Skills, Knowledge, personnel etc.

3. How realistic is the

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implementation schedule 4. Labour intensive method

or others 5. Cost estimates of

Engineering Data 6. Etc.

10 Socio-cultural assessment Social benefits, community development etc.

11 Environmental assessment Environmental impact, benefits, hazards, risks, clearances etc.

12 Overall assessment of the project proposal (findings of the project appraisal process)

13 Conclusions and recommendations

14 Preliminary framework for project monitoring and evaluation.

15 Remarks if any

3.8.3 Questions :

1. List type of appraisal are PPP projects ? 2. Explain the steps to calculate NPV, IRR and BCR ? 3. Discuss the sensitivity analysis, scenario analysis in PPP projects ? 4. How do you take decision based on NPV, IRR and BCR to judge viability? 5. How do you assess economic feasibility & EIRR ? 6. How do you construct the base PSC model? 7. What are contents of appraisal report of project?