Introduction to International Development. Approaches, Actors, and Issues 9780199018901

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Approaches, Actors, Issues, and Practice

Edited by

Paul A.Haslam Jessica Schafer Pierre Beaudet

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INTRflDUCTIflN

Tfl INTERNATIflNAT DEVET()PMENT Approaches, Actors, Issues, and Practice

PaulA.Haslam Jessica Schafer

Pierre Beaudet THIRD EDITIOI{

oxroRD rJNIVERSITY PRESS

OXFORD UNIVERSITY PRESS

Oxford University Prt>ss is u deparhne.111 oflhe. University of Oxford. It furthers the Unlversll y' objective of excellence in. research, chola..r hip, and cduc111!tm by publishing worldwide. xford is ;1 regisleredtmde mark of Oxford University Press in Lhe UK and in certain other countries, Published in Canada by Oxford University Press 8 Sampson Mews, Suite 204, Don Mills, Ontario M3C OHS Canada www.oupcanada.com Copyright© Oxford University Press Canada 2017 The moral rights of the authors have been asserted Database right Oxford University Press (maker) First Edition published in 2009 Second Edition published in 2013 All rights reserved. No part oftbis publlcatlon may be reproduced, stored in a relriev, I sy Wm, or lran niilled, in any form or by any mean,, w·ithout tl1c prlor pennlssion in wrlling of Oxford University Pre.ss, or, s expressly permitted by law, by licence, or under terms agreed with t·he appropriate rcprograph ics rights organizntion. Enquiries concerning reproduction Dul ide fl1e sc(>p� of Lhe above should be sent to thrAAT)

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The "community development" approach of the 1950s de­ rived from both British experience in "preparing" India for independence in the 1940s and the domestic policy of the United States in the 1930s. Community development then became the guiding logic of American development assistance-primarily in Asia, where rural development was seen as a powerful antidote to communist agrarian movements-and of the United Nations system. Community development was defined as a process, program, and/or movement involving communities in teaching democratic processes and facilitating transfer of technology to a community for more effective solu­ tion of its problems (Holdcroft, 1976: 1-3). The "rural reconstruction" movement in pre-independence India had demonstrated that rural people would take initi­ ative when they realized that they would benefit from community-wide efforts. From these roots, community development programs were assumed to have universal relevance as part of a democratic social movement em­ bracing the idea of a balanced, integrated development of the whole of community life.

1ore "partic­ ; also gained g ro" ,rnne-WaKe b.at it is now � 0 response� n, d -0 to the most .) p... large P';- � 3 ted in part Er (ti � '"" biof·d , 111 0.. 0 e-led "inte­ i3' � Cl' ri:t � a "9 � 1970s and ls began to .... . Of course, 1" rural 8 Anal?sis: A Solnt.ion TrPP

PLANNING PROJECTS AND THE LOGICAL FRAMEWORK When there is a clear idea of the problem to be solved or the opportunity to be exploited, and when it is also clear that some form of investment is required, it is possible to start to plan the project. In doing this, the problem tree helps to define the measures to be taken by the pro­ ject and may also help to identify particular issues that might affect the project but lie outside its jurisdiction. At this point an approach is needed to ensure that what is proposed is logically consistent with the defined ob­ jectives and to define what the project might be. The LF provides a tool that helps in clarifying project design. It is also the final stage in what has come to be known as the LFA, although it was developed earlier and can be used as a stand-alone tool. There are various versions of the LF, but the one illustrated here is the approach used by the European Commission, based on the original German ZOPP model, originally described as the "Project Planning Matrix." The LF is a matrix of four columns and four rows. The vertical logic relates to the hierarchy of ob­ jectives. Project activities lead to project results that contribute to a development outcome or purpose that

contributes to a wider overall objective or development impact. This vertical logic can be examined to ensure that the investment proposed in the project actually contributes to the intended outcome. If a project com­ ponent does not contribute to the outcome, why is it there? The columns provide a description of the various objective levels, the indicators that show whether objec­ tives have been achieved, the means of verification for the indicators, and the important underlying assump­ tions that must hold if each level is to be achieved. The indicators column shows the most important things to be monitored during the implementation of the project and the means of verification column shows where the necessary information can be found. It provides guid­ ance for the development of reporting systems for pro­ ject management. The assumptions column highlights the potential causes of project failure and therefore in­ forms those involved in project appraisal of some of the indicators that may need to be tested through sensitiv­ ity analysis. The LF has been used extensively in many variants in many countries and by many development agencies. A number of criticisms have been raised in the liter­ ature (e.g., Gasper, 2000; Reidar, 2003; Bakewell and Garbutt, 2005). Some critics have described the LF as a

27 I Potts: Planning and Appraising Development Projects

Project Description

Indicators

Means of Verification

Improve family health

Incidence of water-borne diseases reduced by 50%

Hospital and clinic records

Increase incomes of fishing families

Value of fish sales increase by 20% (date)

Fishing catch records

Sustainable fishing practices adopted

National water pollution standard reached by (date)

Water quality surveys

Waste treatment process effective Public awareness campaign effective

Overall objective

Assumptions

Purpose

Improved river water quality

Results

Reduced volume of wastes and wastewater discharged into river

Volume of waste in water reduced by 80% by (date)

Survey of households and factories

New plant completed and in operation (date) program delivered (date)

Project monitoring reports

Upstream river flows and water quality maintained at specified level

Activities

Rehabilitate waste treatment plant Public health awareness program

FIGURE 27.4 I An Example of a Logical Framework: The Project Planning Matrix

"lockframe" (Gasper, 2000) that restricts creative think­ ing because of the rigidity of a 4 x 4 matrix. There are also questions about the terminology used for different levels and the number of levels in the vertical hierarchy. It is not always easy to determine what to put into each level. The version of the LF from the Norwegian Agency for Development Co-operation (NORAD, 1999) has five levels with "inputs" at the lowest level, and the indi­ cators and means of verification are combined so that there are only three columns. There are also different opinions as to whether the assumptions column should only include factors outside the control of the project management. The LF shown in Figure 27.4 is a simplified illus­ tration of what is involved that also illustrates some of the issues that have been raised. In Figure 27.4 there are two "overall objectives." Some would argue, as in the original version of ZOPP, that there should only be one overall goal. This can be achieved easily by add­ ing the word "and" but it doesn't address the point that multiple goals can lead to confusion about what is most important. Strictly speaking, the effectiveness

of the water treatment facility is in the control of the project management, but this is a critical assump­ tion. In some cases of complex projects with multiple stakeholde'rs it may be difficult to fit the project into only four levels. Should we accept the general idea but adapt the tool to the particular needs of the project in question? One of the most important points to be made about the LF is that it only ensures that the project is logical. It does not ensure that the design proposed is the best design, nor does it ensure that the benefits of the project exceed the costs. This is the subject of project appraisal.

PROJECT APPRAISAL Project planning is essentially about project feasibility. Will the project work? Tools like the LF and other pro­ ject identification and design tools help to make sure that the proposed activities of the project will con­ tribute to the proposed output. However, if we want

527

528

PART IV I Practice in International Development

to judge whether a project is a good thing we need to consider four major issues: 1. 2.

3.

4.

Do the overall benefits of the project exceed the costs? Do the net benefits to key stakeholders exceed their costs, i.e., do they have the incentive to participate as assumed? Is the distribution of the costs and benefits of the project such that it can be said to contribute to the development objective? Is the risk of failure sufficiently low for all relevant stakeholders?

To answer these questions for projects with benefits that can be valued without too much difficulty we need some of the tools of cost-benefit analysis (CBA). CBA can be done from the point of view of an individual organization, group, or enterprise. This is described as .financial analysis. It can also be done from the national economic point of view. This is described as economic analysis. Economic analysis can also be adapted to de­ termine who gets the benefits and who pays the costs. This can be described as distribution analysis. In cases where benefits may be difficult to value, particularly in some social-sector projects, we may decide to use the tools of cost-effectiveness analysis (CEA). CEA can also be done from financial, economic, and distributional viewpoints.

Basic Principles of Cost-Benefit Analysis The first basic principle of CBA is that overall benefits should exceed costs. This is a weaker criterion than

the traditional economists' concept of Pareto opti­ mality where a welfare improvement is only certain if everybody is better off. CBA has traditionally adopted the Hicks-Kaldor criterion that welfare improvement occurs if gainers can potentially compensate losers even if the compensation does not take place. CBA therefore allows for the possibility that there may be losers as well as winners, although it is recognized that in some circumstances it may be necessary to compen­ sate the losers. The issue of the distribution of costs and benefits has some significance in such cases. An important issue for CBA is the timing of costs and benefits. When investment takes place, net benefits in the early part of the project will probably be negative, and later on in the project life the benefits will exceed the costs. Where net benefits are initially negative and later positive, we have to have a means to compare ben­ efits and costs at different points of time. The decision criteria used for CBA are based on the principle of time preference. It is assumed that people prefer to have ben­ efits earlier rather than later, so the weight given to costs and benefits in the future is lower than the weight given to present costs and benefits. The standard measures used for comparing costs and benefits over time there­ fore assume that a discount rate (r) is applied to costs and benefits over time with the weight applied to each year falling by a given percentage. By definition the weight given to the present is 1.0 and the present values (PVs) of costs and benefits are calculated by applying discount factors (DPs) to costs and benefits in future years. The higher the value of r, the more weight we put on the present in relation to the future. The issue of choos­ ing the discount rate is therefore related to intergener­ ational issues such as conservation of the environment.

BOX 27.1 I Discount Factors If r is the discount rate and t is the year in the project life, the discount factor 1 Oft= 1/(1 + r)

(DF1)

is given by:

If the discount rate is 8%, the discount factor for Year 1 of a project is 1/1.08 = 0.926 and a benefit or cost of $100 in Year 1 of the project woul d have a PV of $100 x 0.926 = $92.60. The same benefit or cost in Year 2 would have a value of $100 x (1/(1.08)2) = $85.70.

27

I

Potts: Planning and Appraising Development Projects

In estimating the costs and benefits of any project it is useful to distinguish between three categories of costs, namely, investment costs, operating costs, and working capital. Clearly all projects also have some source of revenue, which comes from sales in the case of a commercial project. These categories of costs and benefits will be illustrated with a simplified example of a tomato concentrate project. All values are expressed in thousands of domestic dollars (D$).2 Investment costs are the initial costs required to establish the project and often include replacement costs for items that have an operational life less than the life of the project. Vehicles are replaced in Year 6 and the remaining assets are sold at the end of the pro­ ject life in Year 10. This residual value is recorded as a negative cost. For projects with outputs that are sold the bene­ fits can be described as revenue. However, although all projects should have some benefits, they do not neces­ sarily all have sales revenue. For example, road projects with no toll deliver benefits to road users but they do not have any sales. The distinction between the inter­ nal costs and benefits of a project and the wider impact on society marks the distinction between financial and economic analysis. In our example revenue comes from sales. Note that the value of sales is not always the same as that of production because projects will normally keep some stocks of output to ensure a regular supply to customers. In our example the stocks are sold off in the final operating year. Operating costs are the costs incurred in running the project and can be variable, i.e., they relate to the level of activity of the project, or fixed, i.e., unchanged

by the level of activity. Sometimes particular catego­ ries of cost may include a mixture of fixed and variable costs, e.g., maintenance and operational workers. Working capital includes stocks of materials re­ quired for the normal operation of a project as well as stocks of finished goods (for projects with a physical output) and also financial working capital, mainly credit given by the project to customers (accounts receivable) and credit received from suppliers (accounts payable). Note that what is recorded as a cost is the increase in working capital because the stocks from one period are used or sold in the following period and are therefore recorded in the operating costs. Likewise, credit re­ ceived or given in one period is paid for or received in the following period. At the end of the project life all the stocks of materials are used up, stocks of output are sold, outstanding credit is recovered, and debts are paid off. Once the costs and benefits are determined they can be set out on a year-by-year basis in an annual statement of costs and benefits. This is sometimes de­ scribed, for financial analysis, as a cash flow or, in eco­ nomic analysis, as a resource statement. In this chapter the term "annual statement of costs and benefits" will be used and qualified by factors such as whether it re­ lates to economic or financial costs and benefits and whether it is set out in constant or current prices. Nor­ mally, CBA is conducted in constant prices of the year in which the project is planned to avoid any distortion induced by assumptions about inflation. An example of such a statement for our project is given in Table 27.1. It can be seen that net revenue is negative in Years 1 and 2 and positive in all subsequent years. What is now required is a method to determine whether this is a

TABLE 27.1 I Annual Statement of Costs and Benefits (D$ '000 constant market prices) Year Investment costs

1 4,050.0

Operating costs

Net revenue

3

4

6

5

100.0

7

8

9

10 -1,150.0

100.0

2,407.0 4,712.0 4,950.0

Incremental working capital Total costs Revenue

2

4,950.0 4,950.0 4,950.0 4,950.0 4,950.0

24.5

4,050.0 2,937.2 5,170.0

4,974.5

4,950.0 5,050.0 4,950.0 4,950.0

4,037.3 -1,150.0

2,700.0 5,700.0 6,000.0

6,000.0 6,000.0 6,000.0 6,000.0

6,000.0

950.0 1,050.0 1,050.0

1,962.7

-4,050.0

-237.2

530.0 1,025.5

0.0

1,050.0

0.0

0.0

0.0

-912.7

458.0

430.2

1,150.0

529

5 30

PART IV I Practice in International Development

�--..-.,NC£eJS.....-------------� BOX 27.2 I The Net Present Value (NPV ) This is simply the sum of the net benefits in each year multiplied by the discount factor for that year: �n (B1 -C1) NPV = ""-'t=1 (1 +

,y

The NPV can be calculated using standard spreadsheet functions (e.g., =NPV in Excel).

good project. If we simply add up all the net benefits we do not take any account of the timing of the costs and benefits. As indicated earlier, one way of dealing with time is to apply the method of discounting. The most obvious indicator to use if the discount rate is known is the net present value (NPV). If the NPV is positive at the given discount rate, the project is accepted. If the discount rate is known and there is no problem to secure investment resources (no capital rationing) and no problem of uncertainty about the values of the costs and benefits, the NPV gives a clear and unequivocal decision rule. For this reason it is regarded as the most reliable indicator of the value of a project both for yes/no decisions and for ranking pro­ jects (Belli et al., 2002: 217-19; Curry and Weiss, 2000: 55; Potts, 2002: 73). The NPV indicated in Table 27'.1 is positive at an 8 per cent discount rate and so the project is acceptable at that rate. If the discount rate is not known or is uncertain an alternative indicator can be used. This is the internal

rate of return (IRR). The IRR indicated in Table 27.1 is 13.5 per cent so the project is acceptable at all discount rates up to 13.5 per cent. The IRR is a measure of the efficiency of invest­ ment. It is common practice to estimate both the NPV at specified discount rates and the IRR in order to get a clear indication of the value of a project, but the NPV is regarded as more reliable because the IRR can be mis­ leading when ranking projects (Belli et al., 2002: 222). An example of such a situation is the case of a road im­ provement project where the benefits are measured by vehicle operating cost savings. Assuming a situation of increasing traffic and a deteriorating road, the poten­ tial vehicle operating cost savings will increase every year and the value of the IRR will always increase if the project is delayed (Potts, 2002: 76-7). However, because the process of discounting reduces the value of future benefits, the size of the NPV is reduced if the project is delayed so the NPV can be used to determine the best time to start the road project.

BOX 27.3 I The Internal Rate of Return (IRR) The JRR can be defined as the discount rate at which the NPV is zero or the switching value for the which the NPV changes from a positive to a negative value. IRR =

NPV

at

r where NPV = 0

The JRR can be estimated by estimating the NPV at different discount rates and interpolating, but it is easier and more accurate to use a spreadsheet function (e.g., =IRR in Excel).

27 I Potts: Planning and Appraising Development Projects Another measure that was widely used when CBA was first adopted is the benefit-cost ratio (BCR). This measures the ratio of the discounted value of benefits to the discounted value of costs. A project is acceptable if the BCR is greater than one. This indicator is generally not recommended, partly because different variants can lead to inconsistency and partly because, like the IRR, it is a measure of the efficiency of conversion of costs into benefits and does not indicate the absolute size of the net benefits (Potts, 2002: 69-71). The simple BCR for our project (discounted benefits divided by dis­ counted costs) at 8 per cent discount rate is 1.04, which is greater than one so the project is acceptable.

FINANCIAL ANALYSIS So far the analysis has simply measured the costs and benefits to the project as a whole. There is no indication of how it is to be financed. Net benefits in Years 1 and 2 are negative but we do not know how these costs will be financed. We assume that the project will be financed partly by the shareholders and partly by a loan from a development bank with an interest rate of 8 per cent. A loan ofD$2.5 million is taken out in Year 1, interest due in Year 2 is accumulated into the principal sum of the loan, and the loan is repaid in equal total instalments of interest and principal over a period of eight years from Year 2 to Year 9. To construct a financial analysis for the project it is necessary to draw up a depreciation schedule. In CBA depreciation is not included because the costs and ben­ efits are set out in full in the years when they occur. However, we do need a measure of depreciation for fi­ nancial analysis because governments allow enterprises to write off part of the value of their investment costs as a cost in each year of the asset life. It is assumed that buildings and machinery have potential lives of 20 and 10 years, respectively, and vehicles have a life of four years. It is further assumed that depreciation is calcu­ lated on a straight-line basis. The values in the depreciation schedule are not needed for the CBA, but they are needed to work out how much tax the enterprise will have to pay. This is estimated from the profit and loss account or income statement. Net pre-tax profit is estimated by deducting operating costs, depreciation and loan interest from the

project revenue. Interest includes unpaid interest on the basis of the accruals principle in accounting. The most important schedule for the financial analysis is the cashflow shown in Table 27.2. This shows the flows of cash into and out of the project. Although the annual net cash flow can be negative in some years (in Year 3 in this case), the cumulative cash flow must always be positive; otherwise, the project runs out of money and will not work. Financial analysis is not just about profitability-it is also about whether the finan­ cial plan will work. The return to shareholders can be estimated by deducting the value of their share capital contribution from the annual net cash flow. This can then be dis­ counted to estimate the NPV and IRR to the shareholders. This is an important indicator because the return to the shareholders should exceed the return on their next best alternative investment-either the next best project or the return they could get from lending their money to a bank. In this case the IRR to equity (13.3 per cent) is very similar to the overall IRR to the project (13.5 per cent). The example used is a commercial project because it illustrates a full set of schedules that might be re­ quired. Clearly, a profit and loss account is not relevant to a non-commercial project so the financial analysis of a non-commercial project would not include such a statement. However, a cash flow statement is needed for any project because we need to know that the sources of project funds will be enough to pay for the project activ­ ities. Running out of money is a very common cause of project delay or even project failure. Sometimes this is related to inflation and, in principle, financial analysis should be conducted in current prices. This introduces complications that are outside the scope of this chapter.3 Measures like the NPV and IRR relate the value of initial net costs to later net benefits and are relevant to activities that involve initial investment costs followed by later net benefits. Not all project activities involve investment so sometimes it is necessary to use differ­ ent indicators. This is particularly the case for projects that involve changes in cropping patterns of small­ holder farmers. In the project example used here it is assumed that the factory will get its supply of tomatoes from farmers who would otherwise grow rice. There is no investment of money for the farmers but there are changes in costs and revenue. It is assumed that tomato yields for farmers in the first year are lower than in

531

-23.1

-237.2

IRR to equity

NPV to equity at 8%

Return to equity

13.3%

596.9

-1,550.0

-23.1 189.7

162.8 212.8

50.0 50.0

Annual net cash flow

Cumulative balance C/F

34.5 5,723.1

2,937.2

Total annual cash outflow 4,050.0

Tax

302.6

4,712.0

458.0

Loan repayment

2,407.0

430.2

100.0

216.0

4,050.0

5,700.0

5,700.0

3

Loan interest

Operating costs

Incremental working capital

Investment

Cash outflow

3,100.0

4,100.0

Total annual cash inflow

400.0

2

2,700.0

2,500.0

1,600.0

1

·ooo)

Sales

Loan

Equity capital

Cash Inflow

Year

T BLE 27.2 I Cash Flo"- (D$

361.9

551.7

361.9

5,638.1

378.6

930.3

378.6

5,621.4

152.8

352.9

326.8 145.0

165.6

4,950.0

6,000.0

6,000.0

270.1

1,200.4

270.1

5,729.9

161.3

381.2

137.4

4,950.0

100.0

6,000.0

6

6,000.0

5

191.8

4,950.0

24.5

6,000.0

6,000.0

4

361.0

351.1

351.1 1,912.5

361.0

180.3 5,648.9

170.4 5,639.0 1,561.4

444.6

74.0 411.7

106.9

4,950.0

6,000.0

6,000.0

4,950.0

6,000.0

8

6,000.0

7

1,253.1

3,165.6

1,253.1

4,746.9

191.0

480.2

38.4

4,950.0

-912.7

6,000.0

6,000.0

9

1,150.0

4,315.6

1,150.0

-1,150.0

-1,150.0

10

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(1)

:3

"O

0

(1)

0 (1)