The San Jose Del Monte Water Supply Expansion Project

Transcription

1 The San Jose Del Monte Water Supply Expansion Project Glenn P. Jenkins Queen s University, Kingston, Canada. Eastern Mediterranean University, North Cyprus. Baher El-Hifnawi Cambridge Resources International Inc. Development Discussion Paper Number: Abstract This project is an expansion of the existing water supply system in San Jose Del Monte and is being proposed for funding by the Local Water Utilities Administration (LWUA), a government-owned quasi-corporate entity that provides institutional and financial support to the municipal water districts in the country. The project aims to increase the district s system operational storage in order to meet its projected storage requirements up to the year The additional capacity will serve selected zones of the district s entire service coverage. The evaluation approach for the project assumes that it is an incremental investment and that all sources of revenue and economic benefits are also incremental to the existing operations of the San Jose del Monte Water District. In evaluation of this project, an integrated financial, economic and stakeholder analysis is undertaken. Prepared for: National Economic Development Authority, Government of the Philippines. JEL code(s): H43 Key words: Philippines, investment appraisal, financial analysis, economic analysis, stakeholder analysis, incremental investment.

2 The San Jose Del Monte Water Supply Expansion Project I. Introduction The municipality of San Jose Del Monte is located some 28 kilometers north of Quezon City, one of the major cities in Metropolitan Manila. It is predominantly an agricultural locality, with rice farming and poultry/livestock raising as the main economic activities. But because of urban sprawl, industries have started establishing in the area including marble processing and cement manufacturing companies. In the past years, the local government of San Jose has experienced extreme pressure to expand the coverage of its public utilities and services, including water supply. This is due primarily to the relocation of urban squatters from within the Metro Manila cities to the Sapang Palay Relocation Project and Gumaoc, which are government-developed housing projects in San Jose. Also there has been unprecedented real estate development, i.e., commercial subdivision housing, which has added even more to the natural carrying capacity of the area. The San Jose Del Monte Water District service area consists of 1002 hectares, which is comprised of Barangay Poblacion, Poblacion I, Maharlika, Ciudad Real, Francisco Homes, and the Sapang Palay Resettlement Area. As of 1990, the population of San Jose was 142,047 but it is expected to reach 0.39 million by year Currently, the waterworks facilities of the San Jose Del Monte Water District (SJDM-WD) consist of: 6 independent water supply systems with 13 source facilities; 2 settling basins and 13 storage reservoirs; chlorination facilities; 6.3 kilometers of transmission mains; 7,955 service connections; 202 gate valves and 64 fire hydrants. San Jose Del Monte Water Project 1

3 The district s water sources include groundwater, which are extracted through deep wells, and surface water from the Ipo Dam, which is transmitted from the aqueduct system of the Metropolitan Waterworks and Sewerage System (MWSS) to the La Mesa Treatment Plant, through Sapang Palay. II. Project Description This project is an expansion of the existing water supply system in San Jose Del Monte and is being proposed for funding by the Local Water Utilities Administration (LWUA), a government-owned quasi-corporate entity that provides institutional and financial support to the municipal water districts in the country. The project aims to increase the district s system operational storage in order to meet its projected storage requirements up to the year The additional capacity will serve selected zones of the district s entire service coverage. It is expected that with this project, about 25% of the total required connections in 2005 will be made, i.e., an additional 10,601 service connections. More specifically, the following additional facilities will be constructed as part of the expansion plan: Two 1,000 m 3 ground reservoirs: one at the Sapang Palay Resettlement Area to serve Zone 1; and another at the southern portion of Barangay Santo Cristo, to serve Zone 4; A 20,000 m3 /day capacity treatment plant beside the exisitng treatment plant in Sapang Palay; Four booster pumps of varying capacity for primary and reserve use in pumping water from Zone 1 to Zone 4 and for Ciudad Real; Three deepwells and five pump stations; and Distribution pipelines totaling 31 kilometers, with provision for fire hydrants and valves. San Jose Del Monte Water Project 2

4 To operate the system effectively, it shall be divided into four pressure zones for proper management of water flow over the targeted service area. The raw water from the MWSS aqueduct shall be treated at the municipal treatment plant and then pumped to the Zone 4 reservoir where it will be distributed to the service areas of Zone 4 and Ciudad Real. Measures for preserving water resources shall also be adopted, including a monitoring program for water flow rates, water levels, and water quality; sanitary zoning, and acquisition of necessary water rights. The development of the water system is deemed to be beneficial to the entire municipality because it will not only increase the availability of water supply but also result in increased land values and employment, reduced cost of fire damages, and improved health and sanitary conditions. In the section that follows, a description of the appraisal procedure is made, but it will be noted that valuation of the economic benefits is limited to the direct effects of increasing consumer welfare. III. Integrated Financial, Economic, and Stakeholder Analyses The evaluation approach for the project assumes that it is an incremental investment and that all sources of revenue and economic benefits are also incremental to the existing operations of the San Jose del Monte Water District. As in the Cadiz fishing ports project, an integrated financial, economic, and stakeholder analysis is undertaken. Notable differences in the procedures are as follows: 1. Financial Analysis: The primary interest of LWUA in the financial evaluation of the project is to examine the water district s operational viability. Thus the calculation of both the project s net present value (NPV) and internal rate of return (IRR) are made as traditionally practiced in the NEDA project evaluation methodology. A weighted average cost of capital (WACC) is San Jose Del Monte Water Project 3

5 estimated and used as the discount rate for the total investment perspective cash flow while the water district s required return on equity (ROE) is used to discount the equity perspective cash flow. 2. Economic analysis: A major source of economic benefits for the project is consumer surplus for both paying and non-paying users of water. Using a 1994 estimate of willingness to pay for vended water in Metro Manila, which is assumed to be the main source of water prior to project, the economic price of water and its conversion factor is calculated. The analysis is simplified by assuming that there is no distinction between the value of drinking and nondrinking water Distributive or Stakeholder Analysis: The stakeholders identified in this project include government, paying and non-paying consumers, and labor. 4. Risk Analysis: The NPV of the project s financial cash flows, the economic resource flow, and statement of externalities are tested for variability to changes in the risk environment of the project. Project parameters that are used as risk variables include domestic inflation, investment cost overrun, exchange rate appreciation/depreciation factor, and collection efficiency. 1 This is per NEDA-Infrastructure Staff s suggestion. San Jose Del Monte Water Project 4

6 Part 1: Financial Analysis A. Investment and Operating Parameters 2 1. The main investment components of the project are the acquisition of land and equipment, civil works, engineering studies, construction supervision, and physical contingency. Net present value of total investment requirement is P 320 Million. Table 1 shows the breakdown of the nominal investment cost. 2. The project construction period spans 3 years (years 0 to 3), with operations assumed to start in year 4 (1998). For purposes of the evaluation, the project s operational life is defined to be 30 years, with a provision for liquidation in year The project is being proposed for funding under the loan facility of the Local Water Utilities Administration (LWUA). The 25-year loan, which amounts to P 301 Million, will be disbursed from year 0 to year 3 following the investment phasing. It carries a real interest rate of 4.17% per annum. Repayment of loan starts in year 4 and will be completed in year 29. The rest of the investment requirements are expected to come from the internal funds of the San Jose del Monte Water District. 4. The entire incremental water supply is assumed to have a captive market every year. However, only 75% of the water that is produced is expected to generate revenues. The 25% balance is projected to be non-revenue for various reasons (e.g. system leakage and theft). The water district is assumed to also have non-operating income equal to 10% of water sales. The project s supply and revenue highlights are shown in Table Collection efficiency for billed water is assumed to be constant at 96% throughout the project life, which implies that 4% of annual sales is 2 The parameters used in this project are directly obtained from document provided by the NEDA (Water Supply Feasibility Study By Schema Consult, Inc) or are provided by NEDA technical staff. Where data are missing from the project documents, the values are assumed by the authors for illustrative purposes. San Jose Del Monte Water Project 5

7 accounts receivables. No provision is being made for bad debts. Also, there is no distinction in the water tariffs charged for various users (i.e., commercial, industrial, or household). 6. The average cost of operating and maintaining the water supply project is P 7.57 per cubic meter, in year 0. It is expected to stay constant in real terms but will increase annually by inflation. Components of the O&M cost are salaries and wages, raw water, power and fuel, chemicals, maintenance, and miscellaneous items. 7. The water district is assumed to pay a 35% income tax and tariff/vat on its production inputs. San Jose Del Monte Water Project 6

8 TABLE 1: INVESTMENT COMPONENTS (In Nominal Pesos, Year 0: 1994) TABLE 2: HIGHLIGHTS OF PROJECT SALES AND REVENUES ( In Nominal Million Pesos) San Jose Del Monte Water Project 7

9 B. Constructing the Pre-Cash flow tables There are nine pre-cash flow tables (see Annex) that are built up preparatory to the construction of the nominal and real cash flows. These are: Table 1: Table 2: Table 3: Table 4: Table 5: Table 6: Table 7: Table 8: Table 9: Table of Parameters Inflation Indices and Nominal Exchange Rates Nominal Investment and Depreciation Nominal Loan Schedule Weighted Average Cost of Capital Nominal Revenues Nominal Recurrent Costs Nominal Working Capital Income Tax Liability Calculation 1. Inflation Indices and Nominal Exchange Rates The following assumptions are used as basic information: domestic inflation rate of 8% foreign inflation rate of 3% (US inflation is used because the tradable items are originally quoted in dollar prices at the world market) official peso-dollar exchange rate (OER) of P 39/$1 c, the coefficient of appreciation/depreciation of exchange rate is 0% There are three inflation indices and they are calculated annually as follows from year 0 to year 34: => Domestic inflation Index (DII): (1+ Domestic inflation rate) year => Foreign inflation Index (FII): (1+ Foreign inflation rate) year => Relative Inflation Index (RII): DII / FII The domestic inflation index is used to adjust the values of the investments, revenues, and the operating costs for inflation. The foreign inflation index is mainly used in calculating the relative inflation index, which, in turn, is used to San Jose Del Monte Water Project 8

10 project the nominal or market exchange rate. The adjusted nominal exchange rate (ANER), which accounts for appreciation or depreciation of the exchange rate, is used to convert the dollar prices of the project s tradable components into local currency terms and is calculated as follows: ANER: OER * ( 1+ c ) year * RII 2. Nominal Loan Schedule In constructing the loan schedule we note that the real interest rate of 4.17% needs to be adjusted for inflation before we can calculate the interest payments. This is done as follows: Nominal interest rate (i n ): [(1+ real interest rate) * (1 + inflation rate)] - 1 Repayment of the loan starts in year 4, i.e., 3 years after the first disbursement and ends in year 29. It is calculated as a fixed annual payment based on the opening balance of the loan for that year (OB 4 ), which consists of the principal amount and interest accrued in the prior 3 years Nominal Investment and Depreciation The nominal investment schedule is derived by multiplying each investment component with the corresponding annual nominal exchange rate (for tradable components) or by domestic inflation index for the domestic component. In the deterministic financial case, the investment cost requirements are assumed to be completely accounted for. However, in order to accommodate for a possible upward adjustment in costs (i.e. in the context of sensitivity analysis and risk 3 The annual repayments are calculated using Excel s payment function as follows: => Annual repayment: = - PMT (i n, Repayment period, OB 4 ) San Jose Del Monte Water Project 9

11 analysis) due to unforeseen events, we build into the investment cost an overrun factor (COF). The nominal investment, adjusted for cost overrun, is computed as follows: Nominal Investment Cost: Tradable = $ Real Cost * ANER * (1+ COF) Domestic = P Real Cost * DII * (1+COF) The annual depreciation (AD) of each investment item is calculated using straight-line method (SLM), i.e. dividing the investment cost by years of economic life. The salvage value in year 34 is then estimated by taking the difference between total investment costs (TIC) and total depreciation for 30 years of operation, and adjusted for inflation in year 34. Annual Depreciation: Investment Cost / Economic Life Salvage Value: (TIC Total AD* 30 years) * DII in Y Weighted Average Cost of Capital (WACC) The project s WACC of 13.2% is calculated using available information on the financing shares of loan and equity, the real interest rate on the loan, and the required return on equity. The WACC is estimated as follows: WACC = (Share of loan * Interest rate) + (Share of equity * ROE) 5. Nominal Revenues In projecting the nominal revenues, we multiply the inflation-adjusted average tariff rates to the incremental water supply (net of 25% non-revenue portion per San Jose Del Monte Water Project 10

12 year). Since there is no other expected real change in the fee structure over time (other than that shown in Table 2) and in the demand for water, the increase in the revenues will come solely from inflation. For purposes of sensitivity and risk analyses, however, we consider the possibility of a shortfall in the revenue streams by adjusting the collection efficiency. The nominal revenue (NR) and adjusted total revenues (TR) are calculated as follows: Incremental billed water: Incremental water supply 25% non revenue water Net Water sales: Incremental billed water * Average tariff rate * 96% collection efficiency 6. Nominal Recurrent Costs The average O&M cost per cubic meter of water produced in the project is P7.57, in year 0 prices. This is comprised of salaries and wages (30%), raw water (32%), power and fuel (23), chemicals (1%), maintenance (12%), and miscellaneous (2%). The nominal cost streams are obtained by adjusting the real cost of these items with the annual inflation index. Since it is expected that all costs will not grow in real terms, then the increase in recurrent costs over the 20- year project period will come solely from inflation. Nominal recurrent costs are calculated as follows: Nominal cost: Real cost * DII 7. Nominal Working Capital The working capital schedule consists of the project s accounts receivables, accounts payables, and cash balances. Accounts receivables (AR) are assumed San Jose Del Monte Water Project 11

13 to be 4% of the gross water sales; accounts payables (AP) are 8% of the O&M costs; and cash balances (CB) are 20% of the chemicals, maintenance, and miscellaneous costs. Initial working capital for years 0 to 3 are assumed to be incorporated in the equity contribution of the proponents and therefore not included as a separate item. The changes in working capital are the items that go into the expenditure side of the cash flow. Since the base figures for each of the working capital components are already in nominal terms, it is not correct to adjust them again for inflation. The changes in working capital are calculated as follows: AR = AR t-1 - AR t AP = AP t-1 - AP t CB = CB t - CB t-1 8. Income Tax Calculation The income tax of the project is calculated from its income statement, using all nominal figures obtained from the previous working tables. The income tax liability is calculated as follows: Less: Less: Add: Gross revenues Recurrent costs Earnings before interest and taxes (EBIT) Interest expense Depreciation expense Earnings before taxes (EBT) Carry Forward Losses Taxable Income Less: Income tax liability (@ 35%) Net profit after tax San Jose Del Monte Water Project 12

14 We note that the project s income statement shows positive net profit after taxes starting on the second year of operation. That is, it appears to be a viable operation even after payment of corporation taxes. Although this is indicative of the operating sustainability of the project, it is not a sufficient basis for accepting the project. C. Results of the Financial Analysis The results of the financial analysis are summarized in the financial cash flows, which are constructed from both the total investment and owner s perspectives. For each point of view, a nominal and real cash flow is prepared, over which the project s net present value (NPV) and internal rate of return (IRR) are determined. Regardless of the financing scheme, the project appears to be operationally viable, yielding a positive NPV and an IRR greater than the financial cost of funds. From both the perspectives of LWUA, as the financing source (i.e., banker), and the water district management (i.e., equity holder) the project is an attractive venture because it is shown to be capable of self-sustaining its operations, repaying its debt, and generating a net increase in value for the water district. Table 3 summarizes the financial analysis results of the project. TABLE 3: NPV, IRR, & DISCOUNT RATES OF THE PROJECT Summary of Financial Analysis Discount Rate Nominal Real NPV Nominal Real IRR Nominal Real Total Investment/ Banker 13.2% 4.86% P 1,003 Million P 438 Million 29.6% 20% Equity Holder/ Owner 18.8% 10% P 1,003 Million P 438 Million 58.6% 46.9% San Jose Del Monte Water Project 13

15 D. Sensitivity Analysis The financial net cash flows of the project are tested for responsiveness to changes in the values of key project variables using sensitivity analysis. Choosing the real NPV from both perspectives as the forecasts, the following variables are evaluated for their impacts on the project: (1) Domestic inflation rate; (2) Change in average water tariff; (3) Change in O & M costs; (4) Collection efficiency; (5) Investment Cost Overrun; and (6) Appreciation/Depreciation factor of the exchange rate. Table 4 provides a summary of the sensitivity analysis results. The minimum and maximum values for the values or change in values of the sensitivity variables and the corresponding NPVs are shown. Domestic Inflation Rate: The financial outcomes of the project are sensitive to domestic inflation. Generally, when the inflation rate goes up, the real value of the net cash flows decrease. Thus, it is shown that when inflation increases from 0% to 20%, the real value of the NPV decreases. From the owner s perspective, the impact of inflation is especially important because of its implications on the loan repayment schedule. A higher inflation rate accelerates the amortization schedule, which implies that more cash needs to be available at the earlier years of project operation to keep up with higher interest payments than if it were in a low inflation situation. Change in average water tariff: The project s NPV are sensitive to the tariff rate. It is therefore important that the water district set its tariff rate at a level that will not critically affect its cash flow position. Reducing the assumed tariff levels by up to 5% results in an decrease of 9% in its NPV. This information is important to note in any tariff-rebasing decisions of the water district management or whenever economic/political conditions may call for downward adjustments in the tariff structure. San Jose Del Monte Water Project 14

16 Change in O & M costs: Changes of up to 5% in the real cost of operating and maintenance expenses of the project do not seem to affect the NPVs significantly despite the fact that it accounts for almost 30%, on average, of total revenues. This is no reason, however, for assuming that cost management should not be a primary concern for the project. It is possible that with higher incremental changes in any of the O&M cost items, say power, fuel or labor, more impact may be felt. For instance, a 20% increase is expected to reduce both NPVs by as much as 12% to 14%. Collection efficiency: This factor appears to have a very strong impact on the project s financial outcomes. A reduction in the collection efficiency of up to 80% results in an average decrease of 29% in the NPVs. Billing and collection is a critical link in attaining the project s revenue projections. A more efficient system of collecting payments also means that less resources are being channeled into processing of receivables/debts and efforts can be directed towards addressing problems in service delivery and in reducing system losses. Investment cost overrun: The project appears to be sensitive to investment cost overrun despite the provision of a physical contingency item as a separate investment component and adjusting for inflation. This is because physical contingency only averts the negative impact on the quantity-side aspect of project planning and adjusting for inflation does not necessarily address real increases in costs. Overruns on the investment cost are critical because investments occur in the initial years of the project when cash is scarce and the opportunity cost of capital is higher relative to latter years. Appreciation/Depreciation factor of the exchange rate: The project does not appear to be very responsive to changes in the value of the exchange rate. In a project where the tradable components comprise less than 1% of the yotal investment costs, this is expected. San Jose Del Monte Water Project 15

17 TABLE 4: RESULTS OF SENSITIVITY ANALYSIS Sensitivity Variable Range Real Net Present Values Domestic inflation rate TI Owner Base = P 1,003 M Base = P 438 M 0% (Base: 8%) 20% Change in O%M Costs -5% (Base: 0%) 5% Change in Real Average -5% Water Tariff (Base: 0%) 5% Collection Efficiency 80% (Base: 96%) 100% Investment Cost Overrun -5% (Base: 0%) 5% Appreciation/Depreciation Factor of Exchange rate (Base: 0%) -10% % San Jose Del Monte Water Project 16

18 Part 2: Economic Analysis The first step in the economic analysis of the project is the estimation of the economic value of its main output and inputs. Since the national parameters, i.e., the economic opportunity cost of foreign exchange and economic opportunity cost of capital are already calculated in the previous chapters of the manual, they are simply applied in this part of the project evaluation. Once the economic prices are derived, the commodity-specific conversion are obtained and applied on the financial cash flow to derive the economic resource flow. There are four types of distortions that affect the project, which cause the financial prices of its output and inputs to be different from their economic prices. These are tariffs, value added taxes, personal income taxes, and subsidy. The economic price of project items affected by any of these must be adjusted to account for their true economic value. Tradable inputs of the project are also adjusted for a 15.24% foreign exchange premium. A. Economic benefits of the project The economic benefits of the incremental water supplied by the project consists of the value of increased consumption and the value of resources released by the reduced production of other water sources (e.g. vendors). Over its 30 years of operation, gross economic benefits amount to P 2.52 Billion. Specifically, from the economic resource flow statement, there are two major sources of these benefits : (1) revenues from sale of water to paying users and (2) the economic benefits accruing to non-paying water users. Three other items in the inflow side of the economic resource flow are: change in accounts receivables, salvage value of land, and salvage value of other assets. The first two turn out to be negative economic benefits as their financial values are higher than their economic values. There is no externality from the salvage value of other project assets as they are fully depreciated by end of year 33. San Jose Del Monte Water Project 17

19 Sale of water and benefits to non-paying consumers: In order to determine the economic value of water, a distinction is first made between the project s two consuming publics: the paying users and the non-paying users. To simplify the analysis, it is assumed that the value of drinking and non-drinking water is the same. Then an estimate of the price paid for vended water in 1994 by Metro Manila residents is used to represent consumer s willingness to pay for water prior to the project. Adjusted for actual inflation until 1998, the willingness to pay per cubic meter of water is approximately P Given this WTP estimate and using the financial tariff rate in year 4, the following are obtained: (1) the economic price and conversion factor for revenue water ; and (2) the economic value of benefits to non-paying consumers. The calculations are shown below for both types of consumers: San Jose Del Monte Water Project 18

20 It is observed from these estimates that the non-paying consumers are able to obtain a higher economic value from the consumption of water because at the margin they are able to get it for free. B. Economic cost of the project The project has several categories of inputs: tradable, non-tradable, composite, and labor. Labor is divided into skilled and unskilled. The economic price for each type of input mentioned here is calculated separately. Tradable inputs like water supply equipment and cement for the civil and building works are adjusted for the foreign exchange premium on their tradable component and the tariffs and VAT collected by government on their CIF price. Adjustment is also made on the tradable components of the handling (1% of CIF) and transportation (3% of CIF) 4 costs of importing these items. Overall, the magnitude of the economic price relative to the financial price depends on the combined upward effects of the foreign exchange premium on the tradable components of these inputs and the downward 4 The percentage shares of handling and transport were suggested by NEDA staff. San Jose Del Monte Water Project 19

21 effects of the tariff, VAT, and commodity-specific distortions on the handling and transport components. Local inputs like land, sand and gravel, and lumber are adjusted for the VAT on their financial values. The expected conversion factor is generally less than one because the economic value of the VAT is zero. Elasticities of demand and supply for these items were assumed for computational purposes. Local skilled and unskilled laborers are subject to payment of personal income taxes in both their pre-project employment alternative and in the project. Since the project is assumed to pay wages above the market level, there is a gain to government in terms of a higher tax base but there is also a loss in terms of taxes lost in the previous employment of the laborers. The economic opportunity cost of labor accounts for the tax distortions and since the tax rate for skilled labor is higher than for the unskilled group, the conversion factor for the former is lower. The conversion factor for a composite input like civil works is calculated as a weighted average of the conversion factors of its component items. The weights are the cost proportions of each item in the composite to the total cost. A summary of all the conversion factors used in the construction of the economic resource flow is shown in Table 5. D. Present Value of Net Economic Benefits The project s economic NPV, evaluated at a 10.3% economic discount rate, is P Billion. When compared to the financial NPV of P 344 Million, also evaluated at 10.3%, the net economic benefits are over five-fold. Clearly, municipality of San Jose and the Philippine economy stand to gain from this water supply project. San Jose Del Monte Water Project 20

22 TABLE 5: CONVERSION FACTORS FOR PROJECT ITEMS Project Item CF Revenues from sale of water to paying users 1.31 Change in accounts receivable 1.31 Salvage value of land 0.93 Land acquisition 0.93 Water supply equipment 1.02 Civil works 0.92 Engineering studies 0.84 Construction supervision 0.84 Physical Contingency 0.93 Recurrent Costs - Salaries/wages - Raw water - Power - Fuel - Chemicals - Miscellaneous - Maintenance Income tax and VAT 0.0 Change in accounts payable 0.94 Change in cash balances 0.61 The annex table for economic analysis explains the assumptions behind the calculation of these factors. San Jose Del Monte Water Project 21

23 Part 3: Distributive or Stakeholder Analysis A. Deriving the statement of externalities The statement of externalities is built up using the economic resource flow and the real financial cash flow from the total investment point-of-view : Economic resource flow Financial cash flow = Statement of externalities The NPV of the net externalities (inflows outflows) is then determined using the economic opportunity cost of capital (10.3%) as the discount rate. This can be done in two ways: first, take the NPV of each of the line items in the statement and subtract the summation of the outflows from inflows; or second, take the NPV of the net flow line. Doing both is an effective way of checking whether the statement of externalities is correctly defined. The project generates overall net positive externalities to the economy amounting to P 1,475 Million. (See Table 6) This is logical following the result that the economic NPV is almost five times greater than the financial NPV. These externalities are distributed among the stakeholder groups affected by the project, namely: the government, laborers/workers, and water consumers. Reconciling the results of the financial, economic, and distributive analyses, it is clear that the project is able to generate sufficient externalities that reinforce the positive financial outcome: (NPV Financial + NPV EOCK = NPV EOCK , = 1, San Jose Del Monte Water Project 22

24 TABLE 6: PRESENT VALUE OF EXTERNALITIES (In Million Pesos) Cash Flow Item Present Value Economic benefits Benefits to paying users Change in Accounts Receivables Benefits to non-paying users Salvage value land Salvage value other assets Total Benefits 1, Economic costs Investments Land Acquisition Equipment Civil works Engineering studies Construction supervision Physical Contingency Recurrent Costs Salaries/Wages Raw water Power and fuel Chemicals Miscellaneous Maintenance Income tax Value added taxes Change in Accounts Payables Change in Cash Balance Total costs Net Economic Benefits 1, A line-by-line explanation of the allocation of these externalities is provided in the annex table. San Jose Del Monte Water Project 23

25 2. Allocating the Externalities The allocation of externalities to the project s stakeholders is determined by the source of the adjustments or distortions in the calculation of the economic price. There are three general rules that are applied for this project: Whenever taxes or tariffs are paid in the consumption of an item, the externalities are assigned to government. If the project is paying more than the market price to a factor of production, say labor, externalities are assigned to the suppliers of the input here, the workers because the extra wage translates to producer surplus for them. If labor pays taxes, then the externalities are divided among labor and government. Externalities arising from foreign exchange premium on tradable items are also assigned to government. The allocation of externalities that result from the availability of water supply to the service area of the water district are more simple to assign as they are targeted to specific beneficiaries. The only distinction made is in assigning benefits to the paying and non-paying users. Figure 2 shows a distribution of the project s externalities. FIGURE 2: DISTRIBUTION OF EXTERNALITIES Government 33% Labor 1% Non-paying consumers 35% 31% Paying consumers San Jose Del Monte Water Project 24

26 The non-paying users of water receive most of the externalities of the project because they are able to generate higher consumer surplus from not having to pay for the project s outputs compared to the project s paying users. Collectively, the water consumers are the major beneficiaries of the project. The government captures about one third of the net externalities while labor receives the least amount of net benefits. This is despite the assumption that the project pays above market wage, whose positive effect is this case is countered by the personal taxes that are paid on wages. In this analysis, government is considered a separate entity from the LWUA, which is an independent government owned and controlled entity under the Department of Public Works and Highways. The involvement of government in the project consists of three parts: (1) it collects incremental tariffs, value added taxes, and personal income taxes; (2) it bears the cost of foreign exchange premium from the importation of inputs for the project; and (3) it indirectly provides subsidy to the project s consumption of power. 5. Risk Analysis The cash flow projections in the deterministic financial analysis of the project assume that the various project parameters are known over time. It is possible, however, that uncertainty and random fluctuations may cause changes in the values of these parameters. When these changes arise, the risk exposure of the project is increased, which may adversely affect its financial and economic outcomes. Risk analysis conducted using Monte Carlo simulation allows a closer look into the viability of the project by approximating the dynamics and uncertainties of the real world. In the sensitivity analysis of the project, its net present values from both total investment and owner s perspectives were tested for responsiveness San Jose Del Monte Water Project 25

27 to one-time changes in the values of certain project variables. In risk analysis, the project s financial and economic NPV outcomes are tested for variability to changes in those variables that are expected to have the most significant impacts. The following variables were selected as risk variables based on the results of the sensitivity analysis: TABLE 8: RISK VARIABLES AND THEIR IMPACT AND RISK SIGNIFICANCE Risk Variable Impact and Risk Significance Domestic Inflation Investment Cost Overruns Collection Efficiency Exchange rate appreciation/depreciatio n factor Inflation affects the financing requirement of the project through its impact on working capital and interest expenses. If this is not properly anticipated, it may result in a difficult cash position for the project. An unanticipated increase in the real cost of investments may have a sustained effect on the project s cash flow. Overruns are also possible when the project s implementation schedule is not followed on time or when procurement procedures for capital items are not efficiently followed. A decrease in the collection efficiency significantly affects both the level of revenues from incremental billed water and the changes in account receivables over time. Experience among utility companies is replete with examples of financial distress/bankruptcy due to mismanagement of the billing and collection side of operations. Given that a portion of the project s investment and operating costs are tradable, it is possible that real increases in the exchange rate may adversely affect the project s initial cash flow position. Although less than 1% of the investment costs are tradable, testing for the risk impact of this variable is done, more as a matter of exercise than of necessity. San Jose Del Monte Water Project 26

28 A total of 43 risk variables are defined to approximate the risk environment of the project: These are: 35 domestic inflation risk variables from year 0 to year 34; 1 cost overrun risk variable; 6 collection efficiency risk variables for years 4, 10, 15, 20, 25, and 30; and 1 appreciation/depreciation factor for the exchange rate In order to conduct a Monte Carlo simulation, probability distributions are first defined for each of the chosen risk variables of the project. Two types of probability distributions are used to characterize the above risk variables: normal and step distribution. For domestic inflation, collection efficicency, and the exchange rate factor, which are all perceived to have normal distributions, there are two indicators: a mean value that approximates their base values in the deterministic case) and standard deviations that are based on a best estimate of the likely spread of the minimum and maximum values that the risk variables may take. For investment cost overrun, which is perceived to have a custom/step distribution, a range of continuous values with corresponding probabilities is defined. The mean of this distribution (i.e., summation of the midpoints multiplied by the probabilities) approximates the expected value of the variable in a risky scenario. A more accurate definition of the probability distribution of a variable like the inflation rate can be obtained by taking the mean and standard deviation of time series data. For investment cost overrun, definition of the step ranges may be: (a) guided by a project analyst s experience of post-implementation cost deviations in other infrastructure projects; or (b) approached as a way of testing the limits of the project s viability, that is, by assuming high probabilities for high cost overrun ranges. The same principle may also be used in setting up the probability distribution of collection efficiency, which can be based on historical performance of the water district or other similar utility companies. The assumed San Jose Del Monte Water Project 27

29 probability distributions of the four risk variables in the project are described in Table 9. Five project outcomes are defined as the risk analysis forecasts. These are the: Financial WACC Financial ROE Financial EOCK Economic NPV ; and NPV of externalities Monte Carlo simulation uses the probability distributions of the risk variables to simulate changes in the project s risk environment repeatedly and calculates at each instance the value of the five model forecasts. The results of 10,000 trials are then summarized into probability distributions for each of the five forecasts. Table 10 shows the results of the Monte Carlo simulation. San Jose Del Monte Water Project 28

30 TABLE 9: PROBABILITY DISTRIBUTIONS FOR RISK ANALYSIS VARIABLE DISTRIBUTION RANGE DI-0 Domestic Inflation (Number : 35) Normal Mean: 8% Standard Deviation: 2.5% -1% 4% 8% 13% 17% Collection Efficiency (Number: 6) Normal +100%) CE-4 Mean: 96% Standard Deviation: 5% 81% 89% 96% 104% 11 1% Exchange rate appreciation/ depreciation factor (Number: 1) ER-A/D factor Normal Mean: 0% Standard Deviation: 2% -6% -3% 0% 3% 6% Investment cost overrun factor (Number: 1) Custom/ Step Cost Overrun factor Range Probability 0% to 5% % to 10% % to 15% % to 20% % to 25% % to 30% % 8 % 15 % 23 % 30 % San Jose Del Monte Water Project 29

31 TABLE 10: RESULTS OF RISK ANALYSIS Statistic Financial Economic Externalities EOCK NPV NPV Deterministic/Base Value P 344 P 1,818 P 1475 Expected Value (Mean) P 318 P 1,773 P 1,455 Standard Deviation Probability of NPV<0 0% 0% 0% Mean standard error Statistic Financial Financial WACC ROE Deterministic/Base Value P 1,003 Million P 438 Million Expected Value (Mean) P 910 P 407 Standard Deviation Probability of NPV<0 0% 0% Mean standard error The expected values of the five NPV outcomes are not very different from their values in the deterministic case. They confirm what we already know in the financial, economic, and distributive analysis. The riskiness of the project is shown by the standard deviation. As a measure of dispersion, it denotes the average distance of the simulated values from the mean value of the forecast. For this project, the financial and economic NPVs have different levels of risk but all have a zero probability of being ever negative. Since the number of trials used is 10,000, the result appears reliable given the latitude offered for divergence in the risk scenarios implied in these trials. Figure 3 shows the cumulative distribution of the three forecast NPVs for the project. The expected values of each forecast are indicated by the mean lines and the probability of a negative NPV is read off the y-axis. San Jose Del Monte Water Project 30

32 FIGURE 3: CUMULATIVE DISTRIBUTION OF PROJECT NPVs Forecast: Financial EOCK 10,000 Trials Cumulative Chart 61 Outliers Mean = Forecast: Economic NPV 10,000 Trials Cumulative Chart 48 Outliers Mean = 1, , , , , , Forecast: Externalities NPV 10,000 Trials Cumulative Chart 73 Outliers Mean = 1, , , , , , San Jose Del Monte Water Project 31

33 TABLE 11: FACTORS AFFECTING THE VOLATILITY IN NPV (Measured by their % contribution to variance of NPV) Source of Risk ROE WACC EOCK Econ NPV Externalities NPV Investment Cost Overrun Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Domestic Inflation Y Collection Efficiency Y Collection Efficiency Y Collection Efficiency Y Collection Efficiency Y Collection Efficiency Y Exchange rate factor Total* Only the top 10 variables are shown so the total does not add up to 100%. The risk analysis confirms the findings from sensitivity analysis that the investment cost overrun and collection efficiency variables will have a significant impact on the risk of the project. 5 On all three financial NPVs, investment cost overrun is the highest source of variance. This is due to the importance of 5 Recall that in the sensitivity analysis, this factor was tested as a change in the occupancy rate of land spaces and as a change in total revenues separately. To simplify the analysis, the demand factor for the port s 18 different services/facilities was consolidated as a single change in demand variable for risk analysis. A more accurate modeling of demand as a risk variable would be to do it indvidually for each type of port service/facility. San Jose Del Monte Water Project 32

34 investment costs in the cash flow structure of the project during its initial stage of implementation. Collection efficiency figures more prominently in the economic analysis because of the importance it plays in determining the amount of economic benefits/consumer surplus. Domestic inflation does not appear to be a significant source of variability in both the financial and economic outcomes of the project. While this is not a wrong result, it is not totally expected given that the net cash flows were observed to be responsive to it in the sensitivity analysis. This should not however, be misinterpreted as a reason for ignoring the role of inflation in the project s longterm viability. What this means is that we have sufficiently accounted for inflation in the deterministic modeling of the project. San Jose Del Monte Water Project 33

35 IV. CONCLUSION The integrated analysis of the proposed San Jose del Monte water supply project shows that it is both financially and economically viable. As a private sector endeavor, it passes tests for financial viability, using both the NPV and IRR criteria. As a public sector project, it also passes the test for net creation of welfare. Not only does the project generate a significant amount of externalities for the economy, it is also able to provide the largest amount of net benefits to the priority targeted beneficiaries, i.e., the water consumers. One drawback, however, is the issue of non-revenue water. From a purely financial point of view, converting the 25% system loss into real revenues is potentially more beneficial to all stakeholders. The water district management must ensure that this will not increase over time, otherwise it may also translate into a risk factor for the project. The project is also socially attractive in the sense that its gains are spread to other sectors in the economy, namely labor and government. The benefits to government are likely to have local multiplier effects as the national government s and municipality s revenue allocation gets ploughed back into local development projects. San Jose Del Monte Water Project 34