Manual for Development Projects - Planning Commission

Chapter 5
to implement all the projects. It, thus, satisfies a frequent request of the decision-makers that projects be ranked
in the order in which they should be undertaken. It is suitable for use when there is incomplete knowledge of all
the projects. At any given discount rate we cannot, with confidence, use the net present worth, or the internal rate
of return, or the benefit-cost ratio as ranking measures; our criterion tells us only to accept all projects which need
the selection criterion for those three measures. The net benefit-investment ratio is the only measure of the ones
we have discussed that can be used with confidence to rank directly.
Sensitivity Analysis (Treatment of Uncertainty)
5.13 Several times when the project is under execution, certain things go wrong with the project with the result
that the desired benefits cannot be achieved within the stipulated time frame. For example, the actual execution
of the project is delayed or the cost exceeds the original estimated cost (cost over-run). In such cases, the results
get fairly changed. Many times, the IRR and NPW thus get reduced or the BCR becomes negative from positive.
In order to take care of this problem, while the projects are under preparation or under examination, certain
assumptions are applied for testing the viability of the project. For example, it is at times assumed that there will
be a cost over-run by, say, 25% or a reduction in revenues, say, by 10% or a delay in getting the benefits, say, by
three years and so on. Keeping one or two or all such assumptions in view, the streams of costs and benefits are
re-drawn and the figures of costs and benefits are discounted and the NPW, BCR and IRR are re-worked out.
This gives a fairly good picture as to what will be the fate of the projects if such mishaps occur. For the sensitivity
analysis, it is very essential to carry out such an exercise in projects where high financial stakes are involved.
Choosing Between Mutually Exclusive Alternative Projects
5.14 The preferred discount measure of project worth for choosing between mutually exclusive projects is the net
present worth. Direct comparison of IRR, BCR, NBIR can lead to an incorrect investment decision. This is so
because undertaking a small, high - paying project may preclude generating more wealth through a moderately
remunerative but larger alternative. Sometimes what may at first be posed as a pair of mutually exclusive projects
can, instead, be seen as successive phases of development. Although NPW is the preferred criterion for
choosing between mutually exclusive alternatives, it is possible to manipulate the IRR to use it to choose between
the mutually exclusive alternatives. The net benefit-investment ratio can be used to rank mutually exclusive
projects only when the ratios of all the projects in the investment programme are known. Therefore it is not a
practical measure to use for this purpose. To use IRR for mutually exclusive project selection, the cash flow of the
smaller alternative is subtracted year by year from the cash flow of the larger alternative. This stream of
differences is then discounted to determine the internal rate of return of the stream. This is the financial or
economic rate of return to the additional resources necessary to implement the larger alternative as opposed to
the smaller one. This method is only applicable for a single pair of mutually exclusive projects.
Domestic Resource Cost (Modified Bruno Ratio)
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5.15 In countries where there are balance of payments problems and where import substitution or export
promotion is an important objective, it is useful to estimate the cost in domestic currency required to earn a unit of
foreign exchange through a proposed project. It is not enough just to earn or save foreign exchange; some idea
must be formed of the cost of saving foreign exchange and a judgement must be made about whether that cost is
too high. By expressing the cost of earning or saving a unit of foreign exchange as domestic resource cost, a
direct comparison may be made with the official exchange rate and various shadow prices for foreign exchange.
To calculate the domestic resource cost by this method, it is necessary to know four items: (i) the foreign
exchange value of the product to be produced, (ii) the foreign exchange cost incurred to produce the product (that
is, the foreign exchange cost of such things as imported fuels, imported raw materials, and the like), (iii) the
domestic currency cost of producing the output, and (iv) the opportunity cost of capital. The present worth of the
net foreign exchange saving (discounted at the opportunity cost of capital) is compared with the present worth of
the domestic cost of realizing these savings. The ratio between the two present worth is the domestic resource
cost, and it may be directly compared with the official exchange rate or with shadow exchange rates. The
Modified Bruno Ratio formula is given below:
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9/23/2010