Rationale for cost-benefit analysis
In addition to the financial analysis which has been undertaken to examine
the profitability of the proposed National Stadium, it is useful to also consider
an economic assessment of the project. Some of the costs and benefits which
arise from such a project may not have an impact on the profitability of the
enterprise per se, and would not therefore be considered in a financial
analysis of the project proposal. Yet these costs and benefits, which are both
public and private, are still the direct result of the project. Cost-Benefit
Analysis (CBA) is the technique which has been developed to assess the economic
impact of projects. It does so by attempting to assign a monetary value to all
costs and benefits, both private and public, and calculating the discounted
sum of each over the life-time of the project. This often involves assigning
a value to project outcomes which do not have market prices, such as, for example,
the costs of environment damage. In developing a cost-benefit analysis of any
project, however, a number of important methodological issues and judgements
arise, which can have a significant impact on the outcome of the evaluation
exercise. These include the key appraisal parameter used, the assignment of
monetary values or 'shadow prices' where no market prices are available, the
choice of a discount rate and the treatment of risk. We consider each in turn
below.
Key Appraisal Parameter
A number of different appraisal parameters can be used in Cost-Benefit Analysis.
These include the Net Present Value (NPV) of the project, which is the difference,
in monetary terms, between the discounted sums of the costs and benefits of
the project. Thus the value of all future benefits and costs is calculated,
using a specified discount rate (which is discussed further below) to calculate
the value of such future amounts in current terms. The NPV provides a basis
on which to determine whether the return on an investment will be positive or
negative, and with which to compare different potential investments.
A number of other appraisal parameters have also been used. These include the
Internal Rate of Return (IRR) and the Pay-Back period. The IRR is that discount
rate which, when applied to the future streams of costs and benefits the project
produces, will produce an NPV of zero. The Pay-Back period, on the other hand,
is the period of time it takes for the total net benefits of the project to
equal the initial investment. Gray (1995), however, points to a number of problems
with both the IRR and the Pay-Back period as appraisal criteria. The IRR, for
example, does not distinguish between projects of different scale, because it
looks only at the rate of return on outlay, irrespective of the size of that
outlay. Thus, While the IRR and the pay-back period are often used, they
represent short-cuts that are not appropriate as investment appraisal criteria.
1 This position is accepted by the Department of Finance CSF Evaluation
Unit in its recently published Proposed Working Rules for Cost-Benefit Analysis.
The Costs and Benefits of a Project
1
1
Page 2
3
The net socio-economic benefit from a project consists of the additional value-added
arising (i. e. the extra wage and profit incomes it produces), less the social
opportunity cost of the resources involved, plus the net social benefit or cost
arising from 'externalities'. Externalities refers to the effects of the project
on costs and benefits that do not directly accrue or are not directly allocated
in the market pricing mechanism to the project. Externalities are external effects,
which are often referred to as secondary effects or spillover effects.
In estimating the benefits of a project such as the National Sports Stadium,
it has been customary to consider at least three forms of benefit; namely the
direct benefits, the indirect benefits and the induced benefits. The direct
benefits are the value-added within the project itself, while the indirect benefit
is defined as the value-added as a result of the projects purchase of materials
from the rest of the economy. The induced effects are defined as the value-added
as a result of the expenditure within the economy of incomes from the direct
and indirect effects. Department of Finance CSF Unit proposed guidelines argue
that the induced effects should not be included in project analysis, unless
they can be calculated using a rigorous methodology based on data for the Irish
economy. Moreover, given the rate of capacity utilisation in the Irish economy
at present, it is questionable whether any induced benefits could arise from
large capital expenditure projects.
Shadow Pricing
A key issue which arises in cost-benefit analysis is the determination of
'shadow prices' for costs and benefits associated with a project, where no market
prices exist, or where such market prices as do exist are distorted and do not
represent a true economic value. The valuation of resources employed in a project,
for example, should reflect the true economic cost, or 'opportunity cost', of
such resources. The opportunity cost is defined as the value of such resources
in their best alternative use i. e. the benefit foregone by employing the resource
in the project at hand. While techniques exist to develop shadow prices for
a range of project-related costs and benefits, it may not always be possible
to assign a monetary value to all such factors. In cases where it is not possible
to employ rigorous evaluation methods, the Department of Finance recommends
that the problem or benefit be described in qualitative rather than quantitative
terms to facilitate its incorporation as a factor which can influence the policymaker.
This is relevant in the case of the proposed National Stadium as sporting or
civic pride factors are often used to justify such investments, rather than
the economic or financial benefits. A key factor in the evaluation of capital
projects in Ireland in the past has been decisions about the shadow price of
labour. In an economy where there was considerable unemployment, it was argued
that many of the jobs created by an investment project would be additional,
and hence the real opportunity cost of the labour employed would be less than
the wages earned. With the expansion of the Irish economy in recent years and
tightening labour markets, this practice has come to be reviewed, and the Department
of Finance now recommends that labour be valued at 100% of the market wage.
On the other hand, it has been argued that regional labour markets differ, and
that unemployment may be higher in some areas than in others. In such cases,
the Department's CSF evaluation unit argues that a minimum of 80% of the market
wage should be applied, and that such a decision should be
explicitly defended. Another issue which arises in public investments is how
to value public funds. The argument made here is that, in order for funds to
be raised for public investment, it is necessary to levy taxes. Taxes, however,
give rise to distortions. In other words, taxes cause economic agents to alter
their behaviour, and produce outcomes which differ from what would occur were
taxes to be lower or absent. In some cases, these 'distortions' benefit society,
such as where high rates of taxation reduce tobacco consumption. In other cases,
however, they are costly to society, such as where high taxes on labour cause
unemployment traps, or cause employees to reduce the number of hours they are
prepared to work. To take account of these factors, itis argued that public
funds should be valued at a shadow price. Public Finance Theory predicts that
tax distortions vary with the square of the marginal tax rate. Current guidelines
from the Department of Finance CSF evaluation unit suggest using a shadow price
of public 2
2 Page 3
funds of 150%. We believe however that recent trends in the economy and fiscal
policy suggest that this figure may be somewhat high.
Choice of Discount Rate
It was noted above that in calculating the Net Present Value of a project,
it is necessary to discount future flows of costs and benefits so as to express
them in present value terms. The reason for so doing is based in the preference
which society has for benefits in the present as against benefits in the future.
This preference may be somewhat less than the preference which individuals have,
since society as a whole faces lower levels of risk than any individual. Another
way to think about this issue is to consider the alternative uses for public
funds if they are not employed in a major capital project. At a minimum, public
funds could be used to pay off some part of the national debt. Hence the rate
of interest on the national debt is often used as the appropriate discount rate.
Treatment of Risk
Another major factor to consider in evaluating a project is the risk associated
with both the benefits and costs that may accrue from it. While the analyst
may be able to estimate the most likely future outcome, future flows of costs
and benefits may be uncertain, and there may be significant uncertainties surrounding
the outcome of a project. One way to deal with this problem is to vary the discount
rate in accordance with the level of risk attached to a project. This would
be in accord with the practice of financial institutions which alter interest
rates on loans in accordance with the credit rating of the borrower. In the
case of cost-benefit analysis, however, there are problems associated with this
approach. The risks associated with the project, for example, may not increase
on a compound basis, and so the change in the discount rate may not properly
capture the degree of risk involved. This approach would also have the effect
of making it difficult to compare competing projects, since the discount rate
used will significantly depend on the analysts subjective view as to the level
of risk involved. An alternative approach, which is advocated by the Department
of Finance CSF Evaluation Unit, is to develop a scenario analysis, which presents
data based on different possible outcomes.
In Section 8 a detailed analysis of the socio-economic impact of the proposed
National Sports Stadium is presented which incorporates estimates for many of
the factors referred to in this appendix. 3