PAPER NO. : 16, PROJECT APPRAISAL AND IMPACT ANALYSIS MODULE NO. : 25, SCBA-BY FINANCIAL INSTITUTIONS BUSINESS ECONOMICS

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1 Subject Paper No and Title Module No and Title Module Tag 16, Project Appraisal and Impact Analysis 25, SCBA- By Financial Institutions BSE_P16_M25

2 TABLE OF CONTENTS 1. Learning Outcomes 2. Introduction 3. SCBA Methods followed by Financial Institutions 4. Economic Rate of Return 5. Effective Rate of Protection 6. Domestic Resource Cost 7. Summary

3 1. Learning Outcomes After studying this module, you shall be able to Know how industrial projects are evaluated from the social point of view by Financial Institutions. Learn the fundamentals parameters in such evaluation. Identify the different methods adopted by Financial Institutions 2. Introduction The need for social cost benefit analysis (SCBA) for appraising industrial projects in India has been felt since it got its independence. Keeping in view the needs of developing countries, United Nations Industrial Development Organization (UNIDO), Organization for Economic Cooperation and Development (OECD), and World Bank have come up with various methodologies for the same. India is one of the main among developing countries where efforts have been made to apply these methods. Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI) and Industrial Finance Corporation of India (IFCI),the main three all-india term-lending financial institutions in India have adopted one such approach popularly known as partial Little-Mirrlees approach. These institutions however have applied some modifications and simplifications on this approach for appraising their projects. 2.1 Industrial Development Bank of India (IDBI) IDBI was established, as a subsidiary bank of RBI, under the Industrial Development Bank of India Act, 1964, for (i) Providing credit and other facilities for developing industries and (ii) To assist development institutions. In 1976 it was separated from RBI and the ownership was transferred to the Government of India. IDBI is the tenth largest bank in the world in terms of development. The National Stock Exchange (NSE), the National Securities Depository Services Ltd. (NSDL) and Stock Holding Corporation of India (SHCIL) are some of the many Institutions which have been built by support of IDBI. 2.2 Industrial Finance Corporation Bank of India (IFCI) IFCI is the first financial institution set up in July 1948 by a special Act. The main objective was to cater the needs of medium and long term credit of industrial units. The corporation is authorized to issue bonds and debentures in the open market, to borrow foreign currency from the World Bank and other organizations, accept deposits from the public and also borrow from the Reserve Bank. The Union Government has guaranteed the repayment of capital and the payment of a minimum annual dividend. The promotional activities of IFCI include Soft Loan Assistance, Entrepreneur Development, Industrial Development in backward areas, Subsidized Consultancy, Management Development, etc. To improve the professional management the IFCI sponsored the Management Development Institute in It established the Development Banking Centre to develop managerial manpower in industrial concern, commercial and development banks.

4 2.3 Industrial Credit and Investment Corporation of India (ICICI) ICICI was initially established in 1955 as public limited company under the Indian Companies Act, for developing medium and small industries of private sector. In March 2002, the ICICI was merger with the ICICI Bank and created a first universal bank in India. The financial assistance provided by ICICI before its merger with ICICI Bank were lending long term and medium term loans both in terms of rupee and foreign currency, participating in equity capital and in debentures, underwriting new issues of shares and debentures, providing guarantee to suppliers of equipment and foreign lenders. 3. SCBA by Financial Institutions The project appraisal is primarily made by the financial institutions from the financial point of view. ICICI introduced the system of economic analysis followed by IFCI in But the credit of introducing full-fledged system of economic appraisal goes to IDBI. If we compare the approaches followed by the three institutions, there are scant differences. The social cost benefit analysis carried out by the IDBI is based on three concepts: i. Economic rate of return (ERR) ii. Effective rate of protection (ERP) iii. Domestic resource cost (DRC) 4. Economic Rate of Return (Err) This method uses international prices for valuation of trade able inputs and outputs. That is why this approach is also called as partial Little-Mirror less approach. The key elements of this approach are following: (1) USE OF INTERNATIONAL PRICES: This method assumes that international prices reflect the true economic value. So, these international prices should be used as far as it is possible. This is so, because there may be few items in respect of which these prices may not be available. (2) NON-LABOUR INPUTS AND OUPUTS: In the case of trade able items for which international prices are directly available, these international prices are used. It means all non- labor inputs and outputs are valued at international prices. a. Inputs are valued at CIF prices and b. Outputs are valued at FOB prices. (3) USE OF SOCIAL CONVERSION FACTORS : The social conversion factors are used in two cases: (a) For tradable items where international prices are not available and

5 (b) For non-tradable items There are following possibilities: (1) A social conversion factor is applied directly to the actual rupee cost (Like Land). (2) The rupee value of goods may contain some inputs that went into their production and are trade able. That is why social conversion factor cannot be applied directly. In such cases, the actual rupee cost is broken down into three components (See Table 26.1) a. Trade able Component b. Labour Component and c. Residual Component These components are then valued in social terms by applying social conversion factors (Refer Table 26.2). The social conversion factors and weightage for different components used by the IDBI are given in Table 26.1:

6 Table 25.1 SCF or Proportions used by IDBI The social conversion factors for various components (tradable, non-tradable and residual) are same for all goods. They are given in Table Table 25.2 SCF for components The sum of the social value of the components is taken as the social value of the good. Example 1

7 While appraising a project using Economic Rate of Return (ERR), the basis that can be used may be Social Conversion factor (SCF), component-wise SCF or international prices (FOB or CIF). How the basis of conversion is decided? In respect of following items, identify the basis of conversion: Solution RULES FOR BASIS OF CONVERSION The following are the rules for basis of conversion; 1. All non-labor inputs and outputs are valued at international prices wherein Inputs are valued at CIF prices and Outputs are valued at FOB prices. 2. The social conversion factors (SCF) are used for tradable items where international prices are not available and also for non-tradable items. 3. In some cases like building, transport, electricity, water, fuel, etc., the actual rupee cost is broken down into three components tradable, labour and residual.

8 Example 2 Anubhav Engineering Ltd. is appraising a project to produce a product which is presently being imported. The proposed project will have a capacity to substitute the entire volume of imports. The life of the project is expected to be eight years. The project requires the following expenditure: 1. The Initial Outlay [Capital Expenditure] 2. The working Capital 3. The cost of inputs consumed in the process of production

9 The capital expenditure estimates for the project are as follows: (Rs. Crore) The projected annual profitability statement of the company is as follows: (Rs. Crore) The working capital requirement is estimated to Rs. 20 crore (CIF value Rs. 15 crore) and is expected to contain mostly imported raw materials.

10 Solution 2 STEP-I CALCULATION OF SOCIAL COST OF INITIAL OUTLAY This step requires two parts: 1. Splitting all the capital inputs into tradable, labor and residual components and 2. Finding the social values of various components. (Rs. Crore)

11 Calculation of social value of Initial Outlay STEP-2 CALCULATION OF SOCIAL COST OF INPUTS CONSUMED The social value of the various inputs consumed in the process of production can also be estimated: STEP-3 CALCULATION OF SOCIAL VALUE

12 STEP-4 CALCULATION OF CIF VALUE OF OUTPUT CIF value of output = 15,000 x 80,000 = Rs. 120 crore STEP-5 CALCULATION OF SOCIAL NET BENEFIT P.A. Social net benefit per annum = = STEP-6 CALCULATION OF FLOWS OF SOCIAL NET BENEFIT Let us assume that at the end of the life of the project, the working capital will be realized at Rs. 15 crores and the net salvage value of fixed assets is Rs. 2 crore. The flows of social benefits from the project are, STEP-7 TO FIND OUT IRR OF THE FLOWS OF SOCIAL BENEFITS At last the final step is to find out the Internal Rate of Return of the flows of social benefits, which is the economic rate of return from this project. The rate is percent. STEP-8 TO TAKE DECISION The acceptance or rejection of this project now depends on the required social discount rate determined by the appraiser.

13 5. EFFECTIVE RATE OF PROTECTION (ERP) In the today s era of Liberalization, Globalization and privatization, if there is no trade barrier at international border and the domestic industry is weak, then the economy of that country may tumble down. After all it is the responsibility of Government not only to protect its domestic industry against international competition but also to encourage it. That is why Governments of almost all the countries try to protect the home industry through various means like tariffs, import and export restrictions, subsidies, etc. The degree of protection enjoyed by an industry provides an idea about how vulnerable (or otherwise) the industry is, to competition from overseas if the protection is withdraw by the government. The extent to which a project is sheltered is measured by the Effective Rate of Protection (ERP). This degree of protection available to an industry can be measured by expressing the value added by the industry at domestic prices reduced by the world prices. The ERP is calculated using the following formula: ERP= The following are the relevant points: 1. There is a need to calculate value added at domestic as well as world prices. 2. The value added is calculated using the following: Value added = selling price input costs 3. The selling price used is the price net of taxes and excise duties, but including selling commission. 4. The world prices for exported goods are FOB prices. 5. The world prices for imported goods are CIF prices. 6. The traded inputs are valued at both world prices and domestic prices. 7. The non-traded inputs are valued only at the domestic prices. The input cost consists of the costs of the following inputs: 1. Raw materials and stores 2. Power, fuel and water 3. Repairs and maintenance 4. Part of administrative overheads and expenses 5. Selling Expenses The inputs are segregated into trade able and non-trade able on the following lines:

14 i. Raw materials and stores: these are, in general, treated as traded goods. The world prices are estimated at CIF prices. Bulky materials such as sand, whose volume is high compared to their value and also involve substantial transportation costs are treated as non-traded goods. ii. Power, fuel and water: these are treated as non-traded goods except when the cost of fuel is significant. In such cases, it should be valued at both domestic and world prices. iii. Repairs and maintenance: generally a non-traded item, but the value of spares consumed is considered, at both domestic and world prices. iv. Selling expenses: non-traded item. v. Administrative overheads: administrative overheads contain two components: labor cost and other expenses. The labor cost is included in the value added. Therefore, it is not considered. The other expenses, like rent, telephone and telegraph, etc. are traded as non-traded items. The difference between the value of the output and the value of the inputs is called as value added. This represents payment to labour and capital i.e. the surplus available for the providers of capital and labor. Interpretation of value of ERP The value of ERP reflects the degree of protection of home or domestic industry from international competition. The following are the cases: 1. ERP = 0 2. ERP > 0 3. ERP < 0 Example 3 It means that the domestic industry does not enjoy any protection from competition overseas. It indicates presence of protection. It means the domestic industry is more competitive. The following are the values at domestic and international prices of the inputs and outputs of a project:

15 (Rs. Crore) Solution 3 Value added at domestic Prices = Rs. 95 Value added at World Prices = Rs. 60 ERP = = = DOMESTIC RESOURCE COST (DRC) The domestic resource cost (DRC) is the spending required in terms of domestic currency to generate a saving of one unit of a foreign currency. The commonly used foreign currency for estimating DRC is the US dollar. Domestic Resource Cost = x Exchange rate

16 The amount of value added for computation of DRC is estimated as follows: Additional Items Considered in DRC (as compared with ERP) There are two additional items in the above format: 1. Charge on Capital Employed: The charge on capital employed is imputed at 10 percent. Capital employed is the sum of fixed assets and working capital. The charge of 10 percent is applied after breaking down the value into imported and indigenous components and netting out taxes and duties from the two components. 2. Depreciation: Depreciation on capital equipment is charged at 6 percent. Again, the value of capital equipment s is bifurcated into imported and indigenous taxes and duties are netted out before charging depreciation. Relationship between ERP and DRC The concepts of ERP and DRC are closely related as per the following equation: DRC = (ERP + 1) exchange rate Example 4 The following information is available: Value added at domestic Prices = Rs. 222 Crores Value added at World Prices = Rs. 150 Crores Exchange Rate = Rs.58 per Dollar

17 Calculate ERP and DRC. Also verify the value of DRC as per the relationship formula between the two. Solution 4 ERP = = x 100 = 48% DRC = x Exchange Rate = x 58= Verification of Relationship DRC = (ERP + 1) exchange rate = ( ) 58 = Summary The project appraisal is primarily made by the financial Institutions from the financial point of view. The credit of introducing full-fledged system of economic appraisal goes to IDBI. The method is based on L-M approach with some modifications and simplifications. The SCBA is carried out by the IDBI using the three methods Economic rate of return (ERR), Effective rate of protection (ERP) and Domestic resource cost (DRC).