The financial aspects of project preparation and analysis encompass the financial effects of a proposed project on each of its various participants. In agricultural projects the participants include farmers, private sector firms, public corporations, project agencies, and perhaps the national treasury. On the basis of these budgets, judgments are formed about the project’s financial efficiency, incentives, creditworthiness, and liquidity.
A major objective of the financial analysis of farms is to judge how much farm families participating in the project will have to live on. The analyst will need budget projections that estimate year by year future gross receipts and expenditures, including the costs associated with production and the credit repayments farm families must make, to determine what remains to compensate the family for its own labor, management skills, and capital. Part of the income the family will receive may be in food that is consumed directly in the household, so a judgment must be made about this quantity and its value. Even if a family realizes a considerable increase in income or “net incremental benefit” by participating in the project-as a result, say, of borrowing to purchase fertilizers to increase rice production-its absolute income may still be so low that nearly all of the incremental production is consumed in the household. Financial analysis must judge whether the family will then have sufficient cash to repay the production credit for fertilizer. If not, the analyst may have to make a policy judgment about how much to subsidize families with very low incomes.
The farm budget becomes the basis for shaping the credit terms to be made available. The analyst must judge whether farmers will need loans to finance on-farm investment (and if so, what proportion the farmers should invest from their own resources) or to meet some production costs, and whether seasonal short-term credit should be provided for working capital to finance inputs and pay for hired labor. In tree-crop projects with long development periods, such as those for oil palm or citrus, the analyst must judge whether farmers will have adequate income to live on during the period before the trees begin to bear, or whether special financing arrangements must be made to sustain them. The objective of all these judgments is to shape credit terms that will be generous enough to encourage farmers to participate in the project, yet be stiff enough that the society as a whole can capture fairly promptly a share of the benefit from the increased production. This benefit can, in turn, be used to hasten growth by relending it to other farmers or by reinvesting it elsewhere in the economy.
The analysis of farm income will also permit assessment of the incentives for farmers to participate in the project. What will be the probable change in farm income? What will be the timing of this change? How likely are price changes or fluctuations that could affect farm income severely enough that farmers will refuse to run the risk of participating in the project? What will be the effect of subsidy arrangements on farm income, and what changes in government policy might affect the income earned by farmers? Will new subsidies be needed to provide sufficient incentive for the project to proceed?
A similar group of considerations applies to the financial analysis of private firms involved in the project. Will they have capital for expanding facilities? Will they have the working capital needed to carry inventories of farm supplies or stocks of processed goods awaiting sale? What return will the firms realize on their capital investment, and is this sufficiently attractive?
An analysis of the financial aspects of the project’s administration will also be needed. What investment funds will the project need and when? What will be the operating expenses when the project is under way? Will these expenses depend on budget allocations or will the project produce sufficient revenue to cover its administrative costs? Will changes in government policy be needed to finance the project, such as water charges levied in a new irrigation project? What about salary scales for project personnel? How will replacement of equipment be financed?
Finally, the fiscal impact of some projects will need to be considered. Will the increased output yield significant new tax revenues, perhaps from an export tax? Will new subsidies be needed to encourage farmers to participate, and how much will subsidies have to grow as project implementation proceeds? If the administrative costs of the project are not to be met from revenues, how will this affect the national budget in the future? If the project investment is to be financed by a grant or by borrowing from abroad, while the operation and maintenance cost is to be financed from domestic resources, how will this affect the treasury?
The methodology of discounted cash flow discussed in chapters 9 and 10 shows the way in which this financial analysis customarily is set up and the usual elements included in the cost and benefit streams. The methodology enables an estimate of the return to the equity capital of each of the various project participants, public or private. It is then a policy decision whether to change that return by income taxes, special lending terms, price subsidies, or any of the other tools open to society.
The economic aspects of project preparation and analysis require a determination of the likelihood that a proposed project will contribute significantly to the development of the total economy and that its contribution will be great enough to justify using the scarce resources it will need. The point of view taken in the economic analysis is that of the society as a whole.
The financial and economic analyses are thus complementary-the financial analysis takes the viewpoint of the individual participants and the economic analysis that of the society. But, because the same discounted cash flow measures (discussed in chapter 9) are applied in the financial analysis to estimate returns to a project participant and in the economic analysis to estimate returns to society, confusion between the two analyses easily arises. There are three very important distinctions between the two that must be kept in mind. These qualifications are summarized here and are taken up in greater detail later.
First, in economic analysis taxes and subsidies are treated as transfer payments. The new income generated by a project includes any taxes the project can bear during production and any sales taxes buyers are willing to pay when they purchase the project’s product. These taxes, which are part of the total project benefit, are transferred to the government, which acts on behalf of the society as a whole, and are not treated as costs. Conversely, a government subsidy to the project is a cost to the society, since the subsidy is an expenditure of resources that the economy incurs to operate the project. In financial analysis such adjustments are normally unnecessary; taxes are usually treated as a cost and subsidies as a return.
Second, in financial analysis market prices are normally used. These take into account taxes and subsidies. From these prices come the data used in the economic analysis. In economic analysis, however, some market prices may be changed so that they more accurately reflect social or economic values. These adjusted prices are called “shadow” or “accounting” prices and in the analytical system recommended here are efficiency prices, as noted earlier. In both financial and economic analysis projected prices are used, so both rely to a substantial extent on what are, in effect, hypothetical prices.
Third, in economic analysis interest on capital is never separated and deducted from the gross return because it is part of the total return to the capital available to the society as a whole and because it is that total return, including interest, that economic analysis is designed to estimate. In financial analysis, interest paid to external suppliers of money may be deducted to derive the benefit stream available to the owners of capital. But interest imputed or “paid” to the entity from whose point of view the financial analysis is being done is not treated as a cost because the interest is part of the total return to the equity capital contributed by the entity. Hence, it is a part of the financial return that entity receives.
The methodology of comparing costs and benefits discussed in chapters 9 and 10 is the same for either an economic or a financial measurement of project worth, but what is defined as a cost and what is considered a benefit are different. For the moment, it is enough to recognize that there is a difference between economic and financial analysis; we will discuss the differences in detail later.
Policymakers must be concerned about the investment of scarce capital resources that will best further national objectives. This is true whether the resources committed are being invested by the government directly or by individuals within the economy. The techniques of economic analysis presented here help identify those projects that make the greatest contribution to national income. The economic analysis in general allows for remuneration to labor and other inputs either at market prices or at shadow prices that are intended in the system recommended here to better approximate efficiency prices or “opportunity costs”-the amount we must give up if we transfer a resource from its present use to the project. The remainder is then compared with the capital stream necessary for the project. Those projects with the best return to capital, given the total resources available, are then selected for implementation. Inherent in this approach is the assumption that capital is the most important limit to faster economic growth. What is not implicit in the approach is that capital alone causes economic growth. All the productive factors combined in a project contribute to the new income created, but the methods we will be discussing do not address themselves to the question of what the proportionate contribution of each factor is.
Although the analysis will determine the amount of the income stream generated over and above the costs of labor and other inputs, it does not specify who actually receives it. Part of a project’s benefit is usually taken through taxes for purposes outside the project. Part is generally made available to compensate capital owners (including governments) for the use of their money. Part may become the basis of an indirect transfer of income, as is the case if farmers benefiting from a land settlement project are charged less than the full cost of establishing their holdings. The economic analysis applied in this book is silent about such distribution. Once the analyst knows what the more economically remunerative alternatives are likely to be, however, he can choose those that have better effects on income distribution or other social objectives. Although the formal economic analysis will not decide issues of income distribution, the final decision on project investment will be an informed one that is then made in accord with views about income distribution.