Appendix 3 - Comparison of criteria for investment analysis: Farm financial analysis vs project economic analysis

There are important differences between the analytical criteria for farm financial and project economic investment analyses. Gittinger describes these differences: "The point of view taken in the economic analysis is that of society as a whole...... the financial analysis takes the viewpoint of the individual participants..... The methodology of comparing costs and benefits.... is the same for either an economic or financial measurement of project worth, but what is defined as a cost and what is considered a benefit are different. There are three very important distinctions between the two that must be kept in mind." Further citing Gittinger:1/

1/Gittinger, J. 2nd ed. 1982. Economic Analysis of Agricultural Projects. For IBRD. Johns Hopkins Univ. Press, Baltimore.

"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."

A tabular comparison to summarize these differences is given in the accompanying Table C.1 illustrating how the values are treated in farm budgets.

Table C.1 VALUES APPLIED IN FARM BUDGETS FARM FINANCIAL ANALYSIS VS PROJECT ECONOMIC ANALYSIS 1/

ITEM			FINANCIAL	ECONOMIC
Production: Sales Consumed			Farmgate market price ditto	Shadow priced ditto
Off-farm income			Valued as received	Valued as received
Expenses:
	Land owned		n/a	n/a
	Land purchased		Debt service cost	Value product foregone
	Land rented		Share or value paid	Share or value paid
	Interest on equity		2/	n/a
	Land development cost		Market price	Market price
	Depreciation		Market price	Market price
	Debt service:
		interest	At cost	n/a
		amortization	At cost	n/a
	Taxes		At cost	n/a
	Water charges		At cost, may include subsidy	Project economic cost
	Hired labour		Market price	Shadow priced
	Family labour		2/	Shadow wage
	Management		1/	n/a
Operating costs:
Fuel, seed, fertilizer, custom [hired] work, etc			Market price	Full cost, without any subsidy

n/a - not applicable

1/ Gittinger, J.P. 2nd ed. 1982. Economic analysis of agricultural projects. (For IBRD.) Johns Hopkins Univ. Press, Baltimore. Brown, M.L. 1979. Farm Budgets: from farm income analysis to agricultural project analysis. Johns Hopkins Univ. Press, Baltimore.

2/ Values are imputed in a USBR payment capacity analysis. These are based on opportunity cost for the resource.