The module 5 corresponds to the Fiscal, Financial and Economic Analysis (FFEA) of LAPs which contains elements of the three main modules.

Module 5: Fiscal Financial and Economic Analysis (FFEA)

Introduction to CBA

This guide has been developed as a supplement to the theoretical framework and describes the general aspects of cost-benefit analyses (CBA). It also contains various fact sheets, some specific to Module 5, and others that were presented in the other modules.

The CBA is one of the main tools for measuring the efficiency of investments; it quantifies the anticipated costs and benefits of a programme or project with the aim of comparing them and determining whether the benefits outweigh the costs. The CBA consists of a series of calculations that result in incremental net financial or economic flows, and these are used to estimate indicators of the economic or financial feasibility of an investment.

CBA in the project cycle

CBA are usually carried out at different stages in the project cycle. These are:

a) Ex ante (or previous) evaluation
This is carried out before the start of the programme or project implementation. During implementation, the aim of the CBA is to guide the formulation of investment programmes or projects to assess various options for achieving the targets set, as well as decision making about whether to fund the proposed investment. The CBA at this stage is based on projections of the costs and benefits to be generated by the project implementation.

b) Medium term (or intermediate) evaluation
As it name suggests, it is carried out approximately halfway through the implementation period of the programme or project. During implementation, the CBA aims to provide information to managers of programmes or projects on how the implementation is being carried out in relation to what was planned in terms of physical goals and their corresponding benefits, and the costs of implementation. At this stage of the project, the CBA results are usually useful for identifying areas that require attention in particular and for reconsidering options for the management of the project according to its aims and objectives during its second half. In other words, it serves as a management tool for evaluating what has been achieved in the medium term of the project and for decision making according to adjustments which might be necessary during the second half of the implementation.

c) Ex post (or subsequent) evaluation
This is carried out at the end of the implementation of the programme or project to be evaluated. During the implementation, the CBA seeks to evaluate whether the investment as implemented was economically or financially beneficial, as determined during the ex post evaluation. The results of the ex post CBA are compared with the results of the ex ante CBA and if there is a significant difference between the indicators of both, an attempt is made to identify the reasons for this difference. To do this, however, the same assumptions must be used during the ex post CBA as during the ex ante CBA (for example duration of the analysis period, discount rate, etc.). The analysis of the causes of any differences may be useful for identifying factors of success or failure, validating assumptions established during the project preparation, and thus generating information which may be useful for a new stage of the programme or project in another region or country.

Types of CBA

CBA can be financial (F-CBA) or economic (E-CBA). The following table describes the main differences between them.

Aim: The aim is to use cash flow forecasts for the project to estimate the financial suitability of a programme or project. It includes the calculation of the financial internal rate of return (F-IRR) and of the financial net present value (F-NPV).

Perspective/Focus: Evaluates whether the project generates sufficient financial returns to meet the corresponding investment and operating costs. It is performed from the perspective of the investor. It uses market prices.

Costs and benefits: Includes effective monetary costs and benefits.

Discount rate: Uses a market discount rate which reflects the opportunity cost of capital on the financial market.

Prices: Uses market prices, i.e. the purchase/sale price of goods or services on the market.

Aim: The aim is to use forecasts of the economic cost and benefit flows of a programme or project to estimate its economic suitability. It includes the calculation of the economic internal rate of return (E-IRR) and of the economic net present value (E-NPV).

Perspective/Focus: Evaluates the contribution of the project to economic wellbeing from the perspective of society in the region or country considered. The analysis uses economic values (shadow prices) which express the value that society is prepared to pay for goods or services.

Costs and benefits: Includes opportunity costs or benefits for society as a whole. They can differ from the financial costs or benefits of the F-CBA insofar as: (a) market prices differ from shadow prices which are obtained using a social conversion factor that corrects price distortion caused by market failures; (b) they include external factors that give rise to social costs and benefits disregarded by the F-CBA as they do not generate real monetary costs or revenue (for example the impact on the environment or redistributive effects); and (c) they exclude subsidies and indirect taxes on intermediate consumption and the goods and services produced.

Discount rate: Uses a social discount rate. It reflects the opportunity cost of capital which is withdrawn from the economy to fund the project.

Prices: Uses shadow prices, i.e. the opportunity cost of goods, which is a better reflection of the real economic cost of the factors used and the real benefits of the results produced for society.

For further information, see the Fact sheet on the Cost benefit analysis of LAPs.

The main differences between F-CBA and E-CBA

The main differences between F-CBA and E-CBA

Indicators used for CBA

As explained in the conceptual framework of Module 5, the main indicators for measuring the economic and financial feasibility of LAPs are the Internal Rate of Return (IRR) and the Net Present Value (NPV). When dealing with financial analysis, i.e. from the investor’s point of view, we refer to these indicators as the financial IRR (F-IRR) and the financial NPV (F-NPV). When an economic analysis is involved, i.e. from the perspective of society as a whole, we refer to these indicators as the economic IRR (E-IRR) and the economic NPV (E-NPV). However, the formulas are the same in both cases. The formulas for calculating these indicators are given below. It should be noted that all the computerized data or spreadsheet management programs most commonly used calculate the value of these indicators automatically by applying the corresponding financial function.

The main indicators used to measure the economic or financial feasibility of investment programmes or projects, including LAPs, are generally the following:

a) Net Present Value (NPV)
The NPV is the present value (updated using a discount rate that represents the opportunity cost of capital) of the incremental net flow of benefits of an investment. As shown in the graph, if the NPV is greater than zero, this means that taking into account the effect of time on the value of money, the benefits of an investment are greater than its costs and the inversion is therefore feasible from the economic or financial point of view, as applicable.

The F-CBA and E-CBA discount rates can be different as both analyses represent different perspectives. In general, it can be said that the financial discount rate should represent the opportunity cost of capital on the financial market, while the economic discount rate should represent the opportunity cost for the state of funding the LAP with regard to other public investment projects.

Representation of the NPV

Representation of the NPV

The formula for the NPV

The formula for the NPV

The NPV is generally defined by the formula.

Ft represents the net flow in each period t.

b) Internal Rate of Return (IRR) The IRR is the highest discount rate that the investment could bear without becoming unfeasible. In other words, and as shown in figure 4, it is the discount rate at which the break-even point is reached at which the NPV is equal to zero. If the IRR is greater than the discount rate, which represents the opportunity cost of capital, the investment is considered feasible as it exceeds the incremental net benefits that the capital would generate with respect to the capital market.

Representation of the IRR

Representation of the IRR

The formula for the IRR

The formula for the IRR

The internal rate of return is defined as the type of interest that cancels out the net present value of the investment.

Ft is the net flow in each period
n is the number of periods considered
l0 is the initial investment value