PROJECT ANALYSIS AND MANAGEMENT

Assignment Two

YARDSTICK INTERNATIONAL COLLAGE DEPARTMENT

OF BUSINESS ADMINISTRATION

MASTER OF BUSINESS ADMINISTRATION (MBA)

Name Of Instructor: - Dr. Zegeye Habtemariam

Name Of Student: - Fikreslasie Lema ID; - MBAO/6145/14A

Submission Date; 26 /2/2023

ACKNOWLEDGEMENT

First of all I would like to thank my Almighty God for his mercy and grace in all
aspects of my life. I sincerely thank my instructor Dr. Zegeye Habtemariam for
your good academic lecturing.

i
Contents
1. Introduction............................................................................................................................1
2. Financial Analysis of a project..............................................................................................1
2.1. Introduction.....................................................................................................................1
2.2. Definition of financial analysis.......................................................................................2
2.3. Scope of financial analysis..............................................................................................2
2.4. Importance of financial analysis....................................................................................3
2.5. Approaches in Financial analysis of a project..............................................................3
2.5.1. Non- Discounting methods......................................................................................3
2.5.2. Discounting methods...............................................................................................7
3. Economic Analysis of a project...........................................................................................11
3.1. Introduction...................................................................................................................11
3.2. Definition of Economic analysis...................................................................................12
3.3. Scope of Economic analysis..........................................................................................12
3.4. Important of Economic analysis..................................................................................13
3.5. Objective of economic analysis....................................................................................13
3.6. Rationale for Economic Analysis.................................................................................14
3.7. Valuation and shadow price.........................................................................................14
3.7.1. Pricing in economic analysis or shadow pricing.................................................14
3.7.2. Sources of shadow pricing.....................................................................................16
3.8. Basic Principles of shadow pricing..............................................................................16
3.9. Use of shadow price.......................................................................................................17
3.10. Conversion factors.........................................................................................................18
3.11. Approaches in Economic Analysis...............................................................................19
3.11.1. LM- Approach....................................................................................................19
3.11.2. UNIDO Approaches...........................................................................................19
4. Similarities and differences between financial and Economic analysis of a project......21
Conclusion....................................................................................................................................23
References.....................................................................................................................................24

ii
 1. Introduction

This term paper is the main guideline for project developing and planning for any projects work

at providing the reader with a basic understanding of the concepts and definitions governing

financial and economic analyses. A financial analysis deals with the profitability of a project,

from an investor's perspective. In a financial analysis it compares the costs of the project to the

expected revenue over the project lifespan. This includes costs of financing and taxes or

subsidies. Economic analysis aims to ensure that scarce resources are allocated efficiently, and

investment brings benefits to the project as well as country and raises the welfare of its citizens.

All resource inputs used by a project have an opportunity cost because, without the project, they

could create value elsewhere in the economy. An economically viable project requires the least-

cost or most efficient option to achieve the intended project outcomes, generating an economic

surplus above its opportunity cost; and sufficient funds and the necessary institutional structure

for successful operation and project maintenance.

2. Financial Analysis of a project

2.1. Introduction

Financial analysis is largely confined to individual organizations or their units. It involves a

fairly quantitative, fund-based approach that directly compares the expenses and revenues from a

venture to determine profitability and hence sustainability. Such evaluation may often employ

the financial statement of projects. The balance sheet, the income statement and the cash flow

statement of any projects. A financial analysis will not only helps to understand the company's

financial condition, it also determine its creditworthiness, profitability and ability to generate

1
wealth, but will also provide the project with a more in-depth look at how well it operates

internally work status. Financial analysis is used to evaluate economic trends, set financial

policy, build long-term plans for business activity, and identify projects or companies for

investment. This is done through the synthesis of financial numbers and data. One of the most

common ways to analyze financial data is to calculate ratios from the data in the financial

statements to compare against those of other companies or against the company's own historical

performance.

2.2. Definition of financial analysis

Financial analysis is the process of evaluating business, project, budgets, and other finance

related transactions to determine their performance and suitability.in other words financial

analysis is used to investigate whether an entity is stable, solvent, liquid, or profitable enough to

warrant a monetary investment.

2.3. Scope of financial analysis

The scope of financial analysis in business project is to deal with the following main activities.

Analyze financial ratios to assess profitability, solvency, working capital management,

liquidity, and operating effectiveness.

Compare current performance with historical conditions using trend analysis.

Compare with peer companies or industry averages to find out how well companies are

performing.

2
 2.4. Importance of financial analysis

Financial analysis uses company's position in relation to the sector of activity, which

allows keeping an eye on the competition.

Financial analysts consider the potential risks that can affect the market. This can be

useful in building an effective business strategy and minimizing your exposure to these

risks.

This analysis is very useful when you need to claim funds or apply for loans. Most

financial institutions require a balance sheet with a financial analysis to determine

company's ability to repay the loans will receive.

This analysis is therefore a valuable health check-up that will help a better understand to

company's needs. It can provide with a more comprehensive overview of a company's tax

situation and help to optimize its management, which could ultimately lead to greater

profits and increased financial security.

2.5. Approaches in Financial analysis of a project

There are a number of approaches for cost and benefits analysis. We can categories these

approaches into non discounted and discounted measures of project worth. Measures of project

worth are discussed below..

2.5.1. Non- Discounting methods

The non-discounting measures are the naive methods of choosing among the alternative

projects.

3
Ranking by Inspection

This method is based on the size of costs and length of cash-flow stream. Suppose, if two

projects are with the same investment and the same net value of production, but with difference

in the length of period then the project with longer duration is preferred to the one with shorter

time period. This leads to bias in the choice obviously due to the absence of more elaborate and

appropriate analysis. In some cases, we can tell by simply looking at the investment cost and the

"shape" of the stream for the net value of incremental production that one project should be

accepted over another if it should choose. In general, there are two such instances to conclude

ranking bay inspection

With the same investment, two projects produce the same net value of incremental

production for a period, but one continues to earn longer than the other.

In other instances, for the same investment, the total net value of incremental production

may be the same, but one project has more of the flow earlier in the time sequence.

Payback Period

Payback period is the simple method of calculation a project by the length of time required to get

back the investment on the project. The payback period of the project is estimated by using the

straight forward formula.

Investment of the project I

Payback period of the project ∈ years ,= = Where,
Annual net cash revenue E

P = Payback period of the project in years,

I = Investment ofthe project

4
E =Annual net cash revenue

The preference of a particular project is based on the lesser payback period.

The two important weakness of the payback period to estimate the time is

It fails to consider earnings after the payback period. Therefore the pay pack period is an

inadequate criterion for the choice a project.

It does not take into account the timings of the time value of money.

Proceeds per unit outlay

Projects are sometimes ranked by the proceeds per unit out lay; this describes the total net value

of incremental production divided by the total amount of the investment.

In other words this is worked out by dividing the total receipts from the total amount of an

investment, and a given project is ranked based on the highest magnitude of the parameter.

Total proceeds
Proceeds per unit outlay=
Total amount investment

The weakness of this method of non- discounting is

The criterion for proceeds per unit of outlay fails to consider timing or time value of money;

money to be received in the future weighs as heavily as money in hand today.

5
Average rate of return

The Average Rate of Return or ARR, measures the profitability of a project on the basis of the

information taken from the financial statements rather than the cash flows. It is also called

as Accounting Rate of Return.

Average incom
Average Rate of Return=
investiment
average life of the project
the

Where,

Average Income = Average of post-tax operating profit.

Average Investment =
( book value of investments at the end erage incom )
Book value of investment ∈the beginning+¿

Advantage of Average Rate of Return

It is very simple to calculate and easy to understand

The measures the profitability of the entire project since it considers the cash flows

throughout the life of the project.

It is based on the accounting information which is readily available and easily understood

by the businessmen.

Disadvantage of Average Rate of Return

It is based on the accounting information and not on the actual cash flows since the cash

flow approach is considered superior to the accounting approach.

It does not take into consideration, the Time Value of Money.

6
 It is inadequate to differentiate between the projects on the basis of amounts required for

the investment, in case the proposals have the same rate of return.

2.5.2. Discounting methods

Discounting method is one of the financial methods used us to determine whether to accept for

implementing projects that have variously shaped time streams patterns

of when costs and benefits fall during the life of the project that differ from one

another for different durations. This Discounting method is explained that the dollar today is

worth more than a dollar tomorrow. For this reason, costs and benefits that occur during the

project life do not have the same value depending in which year they occur. The later a benefit or

a cost occurs; the lower will be its value today (or present value). The common approach is to

apply an adjustment factor to future values are;

Net Present Value (NPV)

The sum of all discounted costs and benefits is called the Net Present Value (NPV). This sum

reflects how much the project will earn. If the NPV is negative, the costs outweigh the benefits

and the project is not economically feasible. It is necessary to apply a discount rate to calculate

the NPV. The NPV is an absolute value, and it is dependent on the size of the project. It is

commonly used to compare projects, especially when projects are mutually exclusive.

P1 P2 Pn
NPV = + + …+ −C
(1+i ) t 1 ( 1+i ) t 2 (1+i ) tn

Where,

P1 = Net cash flow in first year,

i= Discount rate,

7
t - Time period, and

C= Initial cost of the investment

Projects with positive NPV are given weightage in the selection compared to those with negative

present values, while zero NPV makes the investor indifferent.

Internal Rate of Return (IRR)

In the computation of Internal Rate of Return (IRR), the time value of money is accounted. The

method of working IRR provides the knowledge of actual rate of return from the different

projects. Thus, IRR is known as 'marginal efficiency of capital or yield on the investment'. It is

the discount rate at which the present values of the net cash flows are just equal to zero, i.e. NPV

= zero. IRR must be found out by trial and error.

The key advantage of NPV and IRR is that they take into account the time value of money - the

fact that money you expect sooner is worth more to you than money you expect further in the

future.

Disadvantages of net present value and internal rate of return are sophisticated and relatively

complicated ways of evaluating a potential investment. Most spreadsheet packages include

functions that can calculate these or you could ask your accountant for help - see help with

investment appraisal

Advantages of IRR

It considers the time value of money.

It takes into account the total cash inflow and outflow.

It does not use the concept of the required rate of return.

8
 It gives the approximate/nearest rate of return.

Disadvantage of IRR

It involves complicated computational method.

It produces multiple rates which may be confusing for taking decisions.

It is assume that all intermediate cash flows are reinvested at the internal rate of return

Benefit-Cost Ratio (BCR)

The Benefit-Cost Ratio is the ratio of discounted benefits (NPV benefits in monetary terms)

relative to its discounted costs (NPV costs in monetary terms). The calculation of the BCR is

similar to the NPV because it needs the same kind of flow of funds. However, the result is not a

value in monetary terms but a ratio, which allows comparing alternatives with different NPVs.

present worth of gross return

Benefit−Cost Ratio=
present worth of cost

Summary for the criteria of interpreting NPV, IRR and BCR for any project.

Reject the Project If Project Accepted If

Net Present Value(NPV) NPV<0 NPV>=0

Internal Rate of Return(IRR) IRR< Discount Rate IRR>= Discount Rate

Benefit Cost Ratio(BCR) BCR<1 BCR>=1

Modifies internal rate of return

The modified internal rate of return (commonly denoted as MIRR) is a financial measure that

helps to determine the attractiveness of an investment and that can be used to compare different

9
investments. Essentially, the modified internal rate of return is a modification of the internal rate

of return (IRR) formula, which resolves some issues associated with that financial measure.

The MIRR is primarily used in capital budgeting to identify the viability of an investment

project. For instance, if the MIRR of a project is higher than its expected return, an investment is

considered to be attractive.

Conversely, it is not recommended to undertake a project if it’s MIRR is less than the expected

return. In addition, the MIRR is commonly employed to compare several alternative projects that

are mutually exclusive. In such a case, the project with the highest MIRR is the most attractive.

How to Calculate the Modified Internal Rate of Return

Calculating the MIRR considers three key variables:

 The future value of positive cash flows discounted at the reinvestment rate,

 The present value of negative cash flows discounted at the financing rate, and

 The number of periods.

Mathematically, the calculation of the MIRR is expressed using the following equation:

MIRR =
√
n FVFC
PVFV
–1

Where:

FVCF – the future value of positive cash flows discounted at the reinvestment rate

PVCF – the present value of negative cash flows discounted at the financing rate

n – The number of periods

10
MIRR vs. IRR

The modified internal rate of return (MIRR) and the internal rate of return (IRR) are two closely-

related concepts. The MIRR was introduced to address a few problems associated with the IRR.

For example, one of the main problems with the IRR is the assumption that the obtained positive

cash flows are reinvested at the same rate at which they were generated. Alternatively, the MIRR

considers that the proceeds from the positive cash flows of a project will be reinvested at the

external rate of return. Frequently, the external rate of return is set equal to the company’s cost of

capital. Also, in some cases, the calculations of IRR may provide two solutions. This fact creates

ambiguity and unnecessary confusion regarding the correct outcome. Unlike the IRR, the MIRR

calculations always return a single solution. The common view is that the MIRR provides a more

realistic picture of the return on the investment project relative to the standard IRR. The MIRR is

commonly lower than the IRR.

six
Chapter six
Economic Analysis
Economic Analysis
6.1 Introduction
6.1 Introduction
11
 Economic analysis is one step
forward in the project planning
effort. Because as compared
Economic analysis is one step
forward in the project planning
effort. Because as compared
to financial analysis, which
should assess the impact of a
project on the income of its
owners,
to financial analysis, which
should assess the impact of a
project on the income of its
owners,

12
economic analysis is a form of
more general tool of cost
benefit analysis. The use of the
word
economic analysis is a form of
more general tool of cost
benefit analysis. The use of the
word
"economic" implies the analysis
is undertaken is from the point
of view of the nation or the
"economic" implies the analysis
is undertaken is from the point
of view of the nation or the

13
economy as a whole. It can be
seen as a cost benefit analysis
from the social and national
economy as a whole. It can be
seen as a cost benefit analysis
from the social and national
perspective. It ascertains the
overall country impact of a
project. In other words, it is the
perspective. It ascertains the
overall country impact of a
project. In other words, it is the
measure of the costs and
benefits of a project to the

14
society. The exercise of project
appraisal
measure of the costs and
benefits of a project to the
society. The exercise of project
appraisal
is not accomplished till the
proposed project is also viewed
from the economic viewpoint.
is not accomplished till the
proposed project is also viewed
from the economic viewpoint.
Therefore, this unit focuses on
economic analysis and items
included in it.
15
Therefore, this unit focuses on
economic analysis and items
included in it
six
Chapter six
Economic Analysis
Economic Analysis
6.1 Introduction
6.1 Introduction
Economic analysis is one step
forward in the project planning
effort. Because as compared

16
 Economic analysis is one step
forward in the project planning
effort. Because as compared
to financial analysis, which
should assess the impact of a
project on the income of its
owners,
to financial analysis, which
should assess the impact of a
project on the income of its
owners,
economic analysis is a form of
more general tool of cost
benefit analysis. The use of the
word
17
economic analysis is a form of
more general tool of cost
benefit analysis. The use of the
word
"economic" implies the analysis
is undertaken is from the point
of view of the nation or the
"economic" implies the analysis
is undertaken is from the point
of view of the nation or the
economy as a whole. It can be
seen as a cost benefit analysis
from the social and national

18
economy as a whole. It can be
seen as a cost benefit analysis
from the social and national
perspective. It ascertains the
overall country impact of a
project. In other words, it is the
perspective. It ascertains the
overall country impact of a
project. In other words, it is the
measure of the costs and
benefits of a project to the
society. The exercise of project
appraisal
measure of the costs and
benefits of a project to the
19
society. The exercise of project
appraisal
is not accomplished till the
proposed project is also viewed
from the economic viewpoint.
is not accomplished till the
proposed project is also viewed
from the economic viewpoint.
Therefore, this unit focuses on
economic analysis and items
included in it.
Therefore, this unit focuses on
economic analysis and items
included in it
six
20
Chapter six
Economic Analysis
Economic Analysis
6.1 Introduction
6.1 Introduction
Economic analysis is one step
forward in the project planning
effort. Because as compared
Economic analysis is one step
forward in the project planning
effort. Because as compared
to financial analysis, which
should assess the impact of a

21
project on the income of its
owners,
to financial analysis, which
should assess the impact of a
project on the income of its
owners,
economic analysis is a form of
more general tool of cost
benefit analysis. The use of the
word
economic analysis is a form of
more general tool of cost
benefit analysis. The use of the
word

22
"economic" implies the analysis
is undertaken is from the point
of view of the nation or the
"economic" implies the analysis
is undertaken is from the point
of view of the nation or the
economy as a whole. It can be
seen as a cost benefit analysis
from the social and national
economy as a whole. It can be
seen as a cost benefit analysis
from the social and national
perspective. It ascertains the
overall country impact of a
project. In other words, it is the
23
perspective. It ascertains the
overall country impact of a
project. In other words, it is the
measure of the costs and
benefits of a project to the
society. The exercise of project
appraisal
measure of the costs and
benefits of a project to the
society. The exercise of project
appraisal
is not accomplished till the
proposed project is also viewed
from the economic viewpoint.

24
is not accomplished till the
proposed project is also viewed
from the economic viewpoint.
Therefore, this unit focuses on
economic analysis and items
included in it.
Therefore, this unit focuses on
economic analysis and items
included in it
3. Economic Analysis of a project

3.1. Introduction

Economic analysis is one step forward in the project planning effort. Because as compared to

financial analysis, which should assess the impact of a project on the income of its owners,

economic analysis is a form of more general tool of cost benefit analysis. The costs in an

economic analysis are a measure of the resources that a society collectively invests for the

fulfillment of the project. The analysis takes a broader view of the profitability of the project.

This analysis includes the external effects such as environmental impacts and health impacts.

25
The value of external effects is typically assigned using economic opportunity costs or shadow

prices. An economic analysis does not include taxes, tariffs, subsidies, etc. These costs do not

add to economic productivity and are merely transactions between entities within the economy.

3.2. Definition of Economic analysis

An economic analysis is a process followed by experts to understand how key economic factors

affect the functioning of an organization, industry, region or any other particular population

group, with the purpose of making wiser decisions for the future. It is a broader term that can

mean simple and concise or sophisticated and complex identification, study and projection of

economic variables

3.3. Scope of Economic analysis

The scope of economic analyses is dealing with two branches;

I. Microeconomics; Microeconomics is concerned with the economic behavior of

individual decision making units such as households, firms, markets and industries. In

other words, it deals with how households and firms make decisions and how they

interact in specific markets.

II. Macroeconomics. Macroeconomics is a branch of economics that deals with the effects

and consequences of the aggregate behavior of all decision making units in a certain

economy. In other words, it is an aggregative economics that examines the interrelations

among various aggregates, their determination and the causes of fluctuations in them. It

looks at the economy as a whole and discusses about the economy-wide phenomena.

26
3.4. Important of Economic analysis

Economic analysis is used to document that the project net benefit to society as a

whole in relation to public investments

Provide critical inputs to project design and appraisal process.

Economic analysis helps determine, ex-ante, whether a project contributes to a society's

or a country's welfare

It allows organizations and their donors to compare the impact of social intervention to

the cost of implementing it.

It ensures that scarce resources are allocated efficiently, and investment brings benefits to

a country and raises the welfare of its citizens.

3.5. Objective of economic analysis

Economic analysis helps us to make decentralized decisions on the appropriate project

with costs and benefits being defined and valued so as to measure impacts of the projects

on the broad area.

Core Principles of Economic Analysis

There are several core economic principles utilized in economic analysis. These include:

Decisions are made rationally; they are generally made with an outcome in mind.

Costs include money, resources and time expended when producing a product or

providing a service. In addition to financial costs, there is also an opportunity cost. When

you have multiple options to choose from, and you select a particular option

Every choice also has benefits. Benefits are positive results or outcomes from a decision.

27
 There are positive and negative incentives in every decision. A benefit would be regarded

as a positive incentive and a desired result, while a cost would be considered a negative

incentive and undesirable.

3.6. Rationale for Economic Analysis

Economic analysis essentially entails the evaluation of costs and benefits. It starts by ranking

projects based on economic viability to aid better allocation of resources. It aims at analyzing the

welfare impact of a project

3.7. Valuation and shadow price

Economic valuation of project involves converting the financial values into economic values,

also known as “shadow pricing.” This conversion requires economic prices of project outputs

and inputs to be estimated. Economic prices reflect values of goods, services, and other project

effects on the national economy. The basis for estimating economic prices differs between

internationally traded and nontrade goods and services, between project outputs and inputs, and

between incremental and non-incremental outputs and inputs

3.7.1. Pricing in economic analysis or shadow pricing

Shadow pricing is an incredibly useful tool when evaluating a project. Even though shadow

pricing only provides a rough estimate, it helps management assess the value of certain

operations and attempts to place a monetary value on the different tasks associated with the

project. Furthermore, when a company wants to run a cost-benefit analysis, it must use shadow

pricing to assign values to intangible items.

28
Shadow pricing is also frequently used in public policy in order to designate the value of various

public infrastructure projects such as public transportation, parks. Economists seeking the

societal value of projects like public parks will use shadow pricing to demonstrate the benefits of

certain infrastructure projects that are not typically assigned a monetary value.

Advantages pricing

The following are some of the different advantages:

Related Benefit: It is one of the useful tools used to know the benefit related to the

opportunity cost of the use of the resource.

Pricing: It refrains from underpricing.

Economic Opportunity Cost: It considers the Economic Opportunity Cost for

comparison.

Timely Decision: Proactively right project decisions are taken based on cost-benefit

analysis.

Appropriate: These prices are comparatively more suitable for economic calculations

Limitations of shadow pricing

The following are some of the different limitations:

Proof-Less: It is just guesswork, based on subjective assumptions, and is completely

proof-less. So, one should consider other aspects before deciding the shadow pricing for

the decision-making process because there are chances that it could lead to the wrong

decision-making of the company.

29
 Objective: Since it is based on subjective assumptions, it is highly prone to bias. It is so

because the subjective assumptions may vary from person to person, and the person will

make assumptions based only on his understanding.

Inaccurate: There are high chances of wrong estimates in the case of determining the

value using the shadow pricing, and if the estimates are wrong, it would ultimately lead

to the wrong decision-making of the company.

Inflexible: It is a rigid belief, and this inflexibility is one of the limitations that should be

considered before considering it for the decision-making process.

Period: It considers social opportunity cost for the short-run and ignores it in the long

run.

3.7.2. Sources of shadow pricing

 The main sources of shadow pricing arise as results of externalities and the presence

of distortionary market instruments.

3.8. Basic Principles of shadow pricing

Shadow pricing refers to the practice of assigning a monetary value to something whose value

can only be estimated because it is not something regularly bought and sold in a marketplace.

Shadow pricing is often required when a financial analyst is doing a cost-benefit analysis to

decide regarding a proposed investment.

General Principles Shadow Prices are;

There is a shadow price for each regular constraint in a linear optimization model.

30
 The unit of the shadow price is the unit of the objective function divided by the unit of

the constraint.

The shadow price for a given constraint is a mathematically derived quantity. It usually

(but not always) contains extremely valuable economic information about the model that

we would not otherwise be able to easily ascertain.

In terms of microeconomic theory, the shadow price of a given constraint is the marginal

value of the resource whose units are expressed in the constraint.

The shadow price for any non-binding constraint will be zero

3.9. Use of shadow price

Shadow prices are most commonly used in cost-benefit analyses where some elements of the
analyses cannot be quantified by reference to a market price or a cost. The term can also refer to

the maximum price that a business should be willing to pay for one additional unit of some type

of resource. This definition relates to the perceived benefit that management believes it can

obtain from the additional unit. In addition to this the cost of paying overtime to employees to

stay on the job and operate a production line for one more hour. Thus, if the result of keeping

the production line running longer exceeds the cost required to run the line, management should

do so. shadow price can be considered the contribution margin that a business will lose if it does

not engage in a specific activity.

Shadow pricing is useful for incremental decisions, when management needs to know the

benefit associated with the cost of extending the usage of a resource. Doing so can increase

profitability over the long term of a project. Economists will often assign a shadow price to

estimate the cost of negative externalities such as the pollution emitted by a project. Shadow

pricing is an incredibly useful tool when evaluating a project. Even though shadow pricing only

31
provides a rough estimate, it helps management assess the value of certain operations and

attempts to place a monetary value on the different tasks associated with the project.

Furthermore, when a company wants to run a cost-benefit analysis, it must use shadow pricing

to assign values to intangible items. Shadow pricing is also frequently used in public policy in

order to designate the value of various public infrastructure projects such as public

transportation, parks, and bike lanes. Economists seeking the societal value of projects like

public parks will use shadow pricing to demonstrate the benefits of certain infrastructure

projects that are not typically assigned a monetary value.

Disadvantages of Shadow Pricing; A shadow price is frequently a guesstimate for which

there is little proof, especially when it is applied to intangible items. In this case, a range of

estimates can be used, with probabilities assigned to the most likely outcomes in the range.

Even using a range analysis, there is a good chance that any estimates proposed will be

incorrect, and possibly by substantial amounts.

3.10. Conversion factors

Individual project items can be valued at their individual economic prices. However, for ease of

calculation, economic values of project outputs and inputs can also be derived from their

financial values using conversion factors (CFs). A CF is a ratio between the economic value and

financial value of a project output or input. Provided this ratio is assumed constant over a

project’s life, values at financial prices can be multiplied by this ratio to give the corresponding

economic values.

Conversion factor can be calculated at different levels

 For specific items, which are important to a project as the main outputs and inputs;

32
  project specific labor, where labor is an important cost element;

 nontrade inputs, which occur in nearly all projects, for example, transport, water, and

power where the supply of these nontrade inputs is expanded to meet project demand

3.11. Approaches in Economic Analysis

Economic analyses approaches are approaches to index number theory that assumes that the

observed price and quantity data are generated as solutions to various economic optimization

problems.

3.11.1. LM- Approach

This approach propagates the use of shadow prices in order to find out the true value of a project

to society. Saving is the prime yardstick in this approach. We can convert them into investments

at any time in the future. This approach makes the users us the ‘’ border” prices or international

prices. It is so because of the present era of globalization and international trade. Therefore this

approach can Calculate the shadow prices of wages, the goods that traded, and the non-traded

goods too.

3.11.2. UNIDO Approaches

UNIDO stands for United Nations Industrial Development Organization. In this approach, First it

assesses the financial profitability of a project by measuring it at market prices. Usually, Net

Present Value (NPV) of the project. The value inputs or costs and the output or benefits from the

project at market price. However, in the case of projects with social benefits, it can be determine

the net benefits of the project by using the shadow prices of both inputs and outputs. Calculating

the impact of the project on the savings and investment of different income groups can be

Adjusting this impact to the net present value.

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Second step is calculating and adjust the impact of the project on the income distribution by

calculating the value of the effect that a project creates on the distribution of income between the

poor and the rich and between different regions. There is a possibility that the economic benefits

from a project will be more than its social benefits. The result can be vice-versa too. Managers

will use an adjustment factor to make up for the difference. Then they will calculate the correct

NPV of the project.

LM and UNIDO Approaches similarities

 The calculation of shadow price particularly for foreign exchange saving and unskilled

labor is same in both methods.

 Both methods consider factors of equity.

 Both methods use DCF (Discounted Cash Flow) methods.

LM and UNIDO differences

1. UNIDO method also emphasis calculation of financial profitability of market prices at all

but this is not so done in case of LM method.

2. LM method measures cost and benefit in terms of international currency that is in border

price or world price in $. UNIDO approach measure costs and benefits in terms of

domestic currency.

3. The numeracies in case of LM approach measures cost and benefit in terms of

uncommitted social income. On the other hand in UNIDO method it measures the same

in terms of domestic consumption.

4. UNIDO approach focuses efficiency, saving and redistribution of income stage by stage

while LM approach considers the same in totality.

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 4. Similarities and differences between financial and Economic analysis of a

project

Similarities and differences between financial and Economic analysis of a project

Similarity between Economic and Financial Analysis

Financial and economic analyses have similar features. Both estimate the net-benefits of a

project investment based on the difference between with-project and the without-project

situations.

Difference between Economic and Financial Analysis

6.3.1 Opportunity Cost

6.3.1 Opportunity Cost
Before we proceed to the
discussion of shadow price and
its calculation, let us first
outline the
Before we proceed to the
discussion of shadow price and
35
its calculation, let us first
outline the
opportunity costs of
resources because
opportunity cost is the
most important concept
opportunity costs of
resources because
opportunity cost is the
most important concept
underlying economic
analysis. It is defined as
the next best alternative
foregone in

36
underlying economic
analysis. It is defined as
the next best alternative
foregone in
undertaking a course of action.
Whenever, there is an
opportunity cost, there is an
argument
undertaking a course of action.
Whenever, there is an
opportunity cost, there is an
argument
for using shadow prices.
Opportunity cost can best be

37
explained by reference to
examples
for using shadow prices.
Opportunity cost can best be
explained by reference to
examples
commonly used in the economic
analysis of projects: land, labor
and capital.
commonly used in the economic
analysis of projects: land, labor
and capita
Financial Analysis Economic Analysis
 Financial analysis tends to rely on exact  The market price is often modified to arrive at

market prices for calculating costs. what is popularly known as the ‘shadow price’ or

‘economic price’

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 Taxes are treated as costs and subsidies as  Taxes are levied on a project’s returns and are

returns collected by the government itself.

 Interest payments are treated as a cost in  Interest on capital invested by society is also

financial analysis as they are the additional returned to society as a gain on the capital, thus

amount that the stakeholder has to pay to again removing the need for any separate

external bodies along with returning the computation.

borrowed capital.

 A financially feasible project, therefore,  An economically viable project may not always be

might not be economically viable if the financially sustainable. The government may,

overall impact on society is negative. however, choose to take up such a project by

supplying additional funds, owing to its positive

impact on society.

 The financial analysis compares benefits  The economic analysis compares the benefits and
costs to the whole economy.
and costs to the enterprise.

 financial analysis uses market prices to  Economic analysis uses economic prices that are
converted from the market price by excluding tax,
check the balance of investment and the profit, subsidy, etc. to measure the legitimacy of
using national resources to certain projects.
sustainability of a project,

The main traits of the financial and economic analysis respectively are:

Financial Analysis:

 Investor's perspective

 Based on market prices

 Including taxes, tariffs, subsidies etc.

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  Does not include externalities

Economic Analysis:

 Society's economic perspective

 Applies economic prices excluding taxes, tariffs, subsidies etc. to reflect the value of the

project to society.

 Externalities (positive and negative) are included and quantified in monetary terms.

Conclusion

To conclude it can be said that financial analysis is largely confined to individual organizations

or their units. It involves a fairly quantitative, fund-based approach that directly compares the

expenses and revenues from a venture to determine profitability and hence sustainability. On the

other hand Economic analysis takes a much wider view and entails the impact of a project on

society as a whole. It considers the viewpoints of all stakeholders and how the results of a project

align with the broader economic and social policies as well as the International scenario. The

costs in an economic analysis are a measure of the resources that a society collectively invests

for the fulfillment of the project. Both are essentially used to determine the costs incurred and the

resulting benefits from investing in a project. They both involve ascertaining the NPV or the net

present value of a project based on its estimated present and future cash flows, appropriately

discounted. Financial analysis tends to rely on exact market prices for calculating costs. On the

other hand the market price is often modified to arrive at what is popularly known as the

‘shadow price’ or ‘economic price’. Finally financially feasible project, therefore, might not be

40
economically viable if the overall impact on society is negative. Similarly an economically

viable project may not always be financially sustainable.

References

1. Helfert, E. A., & Helfert, E. A. (2001). Financial analysis: tools and techniques: a guide for

managers (pp. 221-296). New York: McGraw-Hill.

2. Peterson, P. P., & Fabozzi, F. J. (1994). Financial management and analysis. New York,,

USA: McGraw-Hill.

3. Vogel, H. L. (2020). Entertainment industry economics: A guide for financial analysis.

Cambridge University Press.

4. Cooter, R. D., & Rubinfeld, D. L. (1989). Economic analysis of legal disputes and their

resolution. Journal of economic literature, 27(3), 1067-1097.

5. Gittinger J. Price 1976. Economic Analysis ofAgricultural Projects, The John

Hopkins University Press, Baltimore, Maryland 2.12118; US.A.

6. King, R.G., and R. Levine. 1993. Finance and Growth: Schumpeter Might Be

Right. Quarterly Journal of Economics 108: 717-37.

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McKinnon, Ronald, I. 1973. Money and Capital in Economic Development. Washington,

DC: The Brookings Institution.

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