Introduction to Economic Analysis

This post will introduce you to economic analysis, differentiating it from financial analysis. Generally, in a project analysis situation, most analyses focus on the cash inflows and outflows of a project. Critical expenses and incomes are usually compared to determine whether a project should be undertaken or not. But expenses and revenues in most financial analyses are mainly the consideration of a private investor.

The implication of financial analysis is that it provides a micro view of a project and concentrates attention on things like accounting profits.

Economic analysis on the other hand considers projects from a macro point of view. The type of questions asked in an economic analysis are:

1. Will the project under consideration lead to the general well being of the community, the state and the nation?

2. Will the project generate employment at various levels in the macro environment?

3. Will the project lead to economic growth?

4. What are the linkages that the project has, i.e., forward or backward linkages?

5. Will the project generate more technical knowledge?

The questions that we have asked are not exhaustive but only go to demonstrate the type of questions that economic analyses seek to answer.

Financial Analysis and Economic Analysis – a Comparison

In general theory, a financial analysis tries to solve resource allocation problems. It tries to use information from projects to determine whether projects should come on stream or not. Economic analysis also tries to solve resource allocation problems in an economy. In economic theory, resources are very scarce and it is part of any good analysis to allocate resources between competing projects. For example, resource allocation problems can arise if a community is trying to decide whether to build a school or a hospital with limited scare resources.

Financial analysis equally tries to allocate resources but from a micro view point. So, both financial and economic analyses solve resource allocation problems.

Financial analysis tries to concern itself with issues of both benefits and costs arising from a project. In the financial analysis, the concern of the analysis is to evaluate the stream of costs attached to a project and deduct same from the stream of benefits.

If the stream of benefits is greater than the stream of costs, then project in question has a positive value and should be accepted, all things being equal. However, if the stream of costs is greater than the stream of benefits, then the project in question has a negative value and should not be accepted, all things being equal.

Economic analysis also concerns itself with costs and benefits arising from a project. If the stream of benefits is greater than the stream of costs, then the project in question has a positive value and should be accepted.

However, if the stream of costs is greater than the stream of benefits, then the project in question has a negative value and should not be accepted, all things being equal. So we could say that financial analysis and economic analysis both concern themselves with costs and benefits arising from a project. In the end, they provide answers to the question of whether a project should be acceptable or not. In evaluating projects, both use discounting and compounding techniques to arrive at their answers.

However, there exist conceptual differences between financial analysis and economic analysis. While financial analysis has a primary objective of establishing the viability and acceptability of a project from a financial view point, paying no attention to society, economic analysis has the objective of establishing the fact that a project is acceptable or not to the society as a whole. So while financial analysis has a micro objective, economic analysis has a macro objective.

Finally, in reaching a decision as to whether or not to accept a project, financial analysis and economic analysis both try to establish a relationship between costs and benefits.

For example in financial analysis, costs and benefits arising from a project are usually defined in monetary variables such as profits. But economic analysis goes really beyond the vague definitions of profit. In Economic analysis, costs are defined in terms of opportunity costs or foregone costs to the society as a whole.

The Nature of Economic Analysis

In economic analysis, the costs and benefits attached to a project are usually compared before a decision can be reached on whether or not to accept a project.

In the literature, there exist three discounted measures of project worth which we will now discuss:

The Net Present Worth

The net present worth is the difference between the present worth of benefits and the present worth of costs. We can write thus:

Generally, according to the net present worth theory, a project is acceptable if the net present worth is positive. If the net present worth is negative, the project will be rejected.

Benefit-Cost Ratio

If you divide the present worth of benefits of a project by the present worth of its costs, then you have what is known as the benefit-cost ratio. We can write thus:

Generally, a project is acceptable if the benefit-cost ratio is greater than 1 (one).

If the benefit-cost ratio is exactly 1 (one), that project is a break-even project.

The Internal Rate of Return (IRR)

The internal rate of return is a discount rate where the present worth of benefits is equal to the present worth of costs.

Under the internal rate of return evaluation method, a project will be acceptable if its internal rate of return is higher than the firm’s required rate of return.

The starting point of economic analysis is the financial analysis of a project which should be properly concluded before embarking on an economic analysis. Some adjustments will be made to the calculations to arrive at economic data.

First, it may be necessary to include or exclude some costs and benefits which may have been included or excluded from the financial analysis.

Secondly, some project inputs and outputs may have to be revalued if their shadow prices differ significantly from their market prices.

Adjustments to Financial Analyses

We have stated that the starting point of an economic analysis is a financial analysis, so if we have financial data on financial analysis, we need to make some adjustments to the financial analysis to arrive at economic analysis data. We shall now consider some of the adjustments:

Transfer Payments

Transfer payments represent transfer of resources from one section of society to another. They do not make any claim on the country’s resources and as such, their impact should be clearly distinguished and analysed in the economic analysis.

One of the first transfer payments we shall consider is interest. Interest is a reward for capital. For example, if a project is funded through a bank loan, the interest component is included in the profit and loss statement.

The interest charges in the profit and loss statement represent transfer payments from a project to the provider of funds. What the project lost (interest) has become a gain to the provider of funds.

In effect, both figures are equal and cancel out without any net increase to society of funds. Therefore in economic analysis, interest charges are excluded since they only represent transfer payments.

The second transfer payment we shall consider is tax. When a project is profitable it is expected to pay taxes to the government at the ruling rate. In computing the profit of a project taxes are deducted to arrive at net profit. Taxes therefore appear as outgoing cash flows. Taxes represent transfer payments from a project to government.

In the economic analysis of a project, taxes are excluded because from the point of view of the society, they are only a transfer of resources from one section of the economy to another.

The third transfer payment is subsidies. In a traditional private sectors setting, it would be unheard of to talk of subsidies. But in economic analysis, subsidies appear as important data. Most public sector projects enjoy government subsidies to enable the poor gain access to certain services which ordinarily they cannot afford without government assistance. Subsidies represent opportunity costs to a nation as a whole. Therefore in estimating the true cost of a project in an economic analysis, subsidies should be included.

Linkage Effects of a Project

Consider a simple case where a university is newly located in an environment. Many investments will begin to spring up. New housing developments will begin to spring up; canteens will begin to spring up; hair dressing salons, etc. will begin to spring up to cater for the needs of the new university community. Such constitute the linkage effects of a project.

Generally, there are two types of linkage effects which we shall briefly discuss:

Forward Linkage Effects

Forward linkage is the stimulus given to industries that use the products of a project. A case in point is a flour manufacturing project. Flour has so many uses. If a flour mill is located in an environment, it will lead to the establishment of such projects as bakeries which will use the flour.

Backward Linkage Effects

Backward linkage demonstrates the stimulus to industries that supply the inputs to a project. For example, the establishment of a flour mill in an environment will lead to demand for wheat which is a major input for flour mill. The flour mill will lead to investment in wheat cultivation.

Also, the establishment of a car assembly plant will lead to the establishment of tyre manufacturing plants that need to supply tyres to the car assembly plant.

Example of an Economic Analysis

In the year 2006, the World Bank was considering the desirability or otherwise of assisting Nigeria set up an ethanol plant covering thousands of hectares in the Niger Delta area.

Under the scheme, young farmers will be allocated hectares of land for subsidized cassava cultivation. Such inputs like fertilizers will be heavily subsidized while technical advice will be provided by the World Bank/ Nigerian agricultural experts.

CONCLUSION

Introduction to economic analysis has provided us with the tools to conduct economic analyses, with financial analyses as a starting point.

Financial analysis is the private sector’s view of a project without considering a project’s impact on the society. Economic analysis is a macro view of a project, taking into consideration the project’s impact on society.