Chapter 6 &7

Chapter Six

Social Cost Benefit Analysis (SCBA)

Social Cost Benefit analysis (hereafter referred to as SCBA) called economic analysis, is a
methodology developed for evaluating investment projects from the point of view of the
society (or economy) as a whole. Used primarily for evaluating public investments (though it
can be applied to both private and public investments), SCBA has received a lot of emphasis
in the decades of 1960s and 1970s in view of the growing importance of public investments
in many countries, particularly in developing countries, where governments have played a
significant role in the economic development. SCBA is also relevant, to a certain extent, to
private investments as these have now to be approved by various governmental and quasi-
governmental agencies which bring to bear larger national considerations in their decisions.

Rationale for SCBA:
In SCBA the focus is on the social costs and benefits of the project. These often tend to differ
from the monetary costs and benefits of the project. The principal sources of discrepancy are:
 Market imperfections
 Externalities
 taxes and subsidies
 concern for savings
 concern for redistribution
 merit wants
UNIDO approach:
Towards the end of the 1960s and in the early 1970s two principal approaches for SCBA
emerged: The UNIDO approach and the Little-Mirrlees approach.
The UNIDO approach was first articulated in the Guidelines for Project Evaluation, United
Nations, 1972 which provides a comprehensive framework for SCBA in developing countries.
The rigor and length of this work created demand for a succinct (brief and to the point) and
Project Analysis and Management By Dereje W. Page 1

operational guide for project evaluation in practice. To fulfill this need, UNIDO came out with
another publication, Guide to Practical Project Appraisal in 1978.
The UNIDO method of project appraisal involves five stages:
1. Calculation of the financial profitability of the project measured at market prices.

2. Obtaining the net benefit of the project measured in terms of economic (efficiency)
prices.
3. Adjustment for the impact of the project on savings and investment.
4. Adjustment for the impact of the project on income distribution.
5. Adjustment for the impact of the project on merit goods and demerit goods whose social
values differ from their economic values.
Little-Mirrlees approach:
I.M.D. Little and J.A.Mirrlees have developed an approach (hereafter referred as the L-M
approach) to social cost benefit analysis expounded by them in the following works: Manual of
Industrial Project Analysis in developing Countries, Vol. II and Project Appraisal and Planning
for Developing Countries.
There is considerable similarity between the UNIDO approach and the L-M approach. Both the
approaches call for:
1. Calculating accounting (shadow) prices particularly from foreign exchange savings and
unskilled labor.
2. Considering the factor of equity.
3. Use of DCF analysis.
Despite considerable similarities there are certain differences between the two approaches:
1. The UNIDO approach measures costs and benefits in terms of domestic currency
whereas the L-M approach measures costs and benefits in terms of international prices,
also referred to as border prices.
2. The UNIDO approach measures costs and benefits in terms of consumption whereas the
L-M approach measures costs and benefits in terms of uncommitted social income.

3. The stage-by-stage analysis recommended by the UNIDO approach focuses on
efficiency, savings, and redistribution considerations in different stages. The L-M
approach, however, tends to view these considerations together.
Foreign Exchange effect of a project:
The UNIDO method uses domestic currency as the numeraire. So the foreign exchange input of
the project must be identified and adjusted by an appropriate premium. This means that valuation
of inputs and outputs that was measured in border currencies has to be adjusted upward to reflect
the shadow price of foreign exchange.
How is the shadow price of foreign exchange established? The Guidelines method determines
the shadow price of foreign exchange on the basis of marginal social value as revealed by the
consumer willingness to pay for the goods that are allowed to be imported at the margin. The
shadow price of a unit of foreign exchange is equal to:
∑ F iQ i P i
i=1
Where Fi is fraction of foreign exchange, at the margin, spent on importing commodity i.
Qi is the quantity of commodity I that can be bought with one unit foreign exchange (this will be
equal to 1 divided by the CIF value of the goods in question)
Pi is the domestic market clearing prices of commodity i.
Example: Commodities 1, 2, 3 and 4 are imported at the margin. The proportion of foreign
exchange spent on them, the quantities that can be bought per unit of foreign exchange, and the
domestic market clearing prices are as follows:
F1 = 0.3, F2 =0.4, F3=0.2, F4=0.1
Q1 = 0.6, Q2 =1.5, Q3=0.25, Q4=3
P1 = 16, P2 =8, P3=40, P4=5
The value of a unit of foreign exchange is:

(0.3)(0.6)(16) + (0.4) (1.5) (8) + (0.2) (0.25) (40) + (0.1) (3) (5) = +Br. 11.180
The calculation of the shadow price of foreign exchange in terms of consumer willingness to pay
is based on the assumption that the foreign exchange requirement of a project is met from the
sacrifice of others. The use of foreign exchange by a project, however, may also induce the
production of foreign exchange through additional exports or import substitution. In such a case,
the shadow price of foreign exchange would be based on the cost of producing foreign exchange,
not consumer willingness to pay for foreign exchange.

Chapter Seven
Project Financing
There are two types of project financing: equity and debt financing. When looking for
money, you must consider your company’s debt-to-equity ratio. The relation between
amounts borrowed and amounts invested to the business by the owners. The more money
owners have invested in their business, the easier it is to attract financing.
The proportion of debt to equity depends on how well the financial market is organized
and the availability of debt financing. In addition, the existence of capital markets and the
legal environment governing it will have a critical impact. However, shortage of financial
resources will be a critical constraint of implementing feasible investment projects.
Equity Financing:
Most small or growth-stage businesses use limited equity financing. As with debt
financing, additional equity often comes from non-professional investors such as friends,
relatives, employees, customers, or industry colleagues.
However, the most common source of professional equity funding comes from venture
capitalists. These are institutional risk takers and may be groups of wealthy individuals,
government-assisted sources, or major financial institutions. Most specialize in one or a
few closely related industries. Venture capitalists may scrutinize thousands of potential
investments annually, but only invest in a handful. The possibility of a public stock
offering is critical to venture capitalists. Quality management, a competitive or
innovative advantage, and industry growth are also major concerns.
Debt Financing:
There are many sources for debt financing: banks, savings and loans, commercial finance
companies, and the microfinance institutions. State and local governments have
developed many programs in recent years to encourage the growth of small businesses in
recognition of their positive effects on the economy.
Family members, friends, and former associates are all potential sources, especially when
capital requirements are smaller. Traditionally, banks have been the major source of
small business funding. Their principal role has been as a short-term lender offering

demand loans, seasonal lines of credit, and single-purpose loans for machinery and
equipment.
In addition to equity considerations, lenders commonly require the borrower’s personal

guarantees in case of default. This ensures that the borrower has a sufficient personal
interest at stake to give paramount attention to the business. For most borrowers this is a
burden, but also a necessity.

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Chapter Six

Social Cost Benefit Analysis (SCBA)

Rationale for SCBA:

Project Analysis and Management By Dereje W. Page 1

The UNIDO method of project appraisal involves five stages:

1. Calculation of the financial profitability of the project measured at market prices.

Project Analysis and Management By Dereje W. Page 2

Foreign Exchange effect of a project:

Where Fi is fraction of foreign exchange, at the margin, spent on importing commodity i.

Pi is the domestic market clearing prices of commodity i.

F1 = 0.3, F2 =0.4, F3=0.2, F4=0.1

Q1 = 0.6, Q2 =1.5, Q3=0.25, Q4=3

P1 = 16, P2 =8, P3=40, P4=5

The value of a unit of foreign exchange is:

Project Analysis and Management By Dereje W. Page 3

Project Analysis and Management By Dereje W. Page 4

Project Analysis and Management By Dereje W. Page 5

In addition to equity considerations, lenders commonly require the borrower’s personal

Project Analysis and Management By Dereje W. Page 6

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