Session 1: Social and Financial Costs and Return in ICT Investments

Session Learning Outcome
Identify and assess the social and financial costs and returns associated with public projects

Important Learning Terms

• Social costs
• Social Cost Benefit Analysis
• Market Imperfections
• Externalities

Social Cost Benefit Analysis (Economic Analysis)
This is a methodology developed for evaluating investment projects from the point of view of the society (or economy) as a whole.
This is used primarily for evaluating public investments.

Why do we need Social Cost Benefit Analysis (SCBA)?

• It helps in decision-making
• It helps in deciding whether a particular project should go ahead or not.
• It helps in comparing different projects

SCBA has received an increasing emphasis in recent years due to.
There is growing importance of public investments in many countries especially developing countries because they play a significant role in economic development.

SCBA aids in evaluating individual projects within the planning framework which spells out national economic objectives and broad allocation of resources to various sectors.

Reasons for the difference between social costs and benefits: and monetary costs and benefit of the project.

1. Market Imperfections
Market prices, which form the basis for computing the monetary costs and benefits from the point of view of project sponsor, reflect social values only under conditions of perfect competition. Which is very rare to occur.
Under market imperfections, market prices do not reflect social values.

These market imperfections include.
(a) Rationing of a commodity valuation which is control over its price and distribution.
(b) Wages and Unemployment.
Because of the imperfections of labour markets in the LDCs different models that production family labour, and presence of large-scale unemployment, it is argued wages paid to labour in LDCs tend to overestimate their three social opportunity cost and cannot be a reliable estimate of the cost of labour to the society. Therefore prescription of minimum wage rates which is usually more than what the wages would be in a competitive labour market
(c) Capital Markets and Interest rates
• Due to the imperfections of the capital markets in Developing countries, interest rates are low.
• This has under estimated the cost of capital to the society. Foreign exchange regulation under which the official exchange rate is typically less than that rate which would prevail in the absence of foreign regulation.
(d) Inflation: In many Developing Countries supply inelasticity, alters the relation prices.
(e) Large Project
Large projects undertaken in small economies are likely to yield significant secondary benefits to the economy. It is not enough to count only the primary benefits of the project.
(f) Protection, Tariffs, Quota etc.
(g) Showering Deficiency and Public Income
(h) Wealth Distribution

2. Externalities (External Economies, Diseconomies, Neighborhood effects)
A project may provide external effects which are known as externalities. Externalities are effects of a project which will result into costs or lead to benefits beyond the confines of the project itself. There are costs and benefits which will accrue to different people, groups in the society, locality or region, other than those targeted by the project as intended beneficiaries. For example, it may create certain infrastructure facilities like roads, which benefit the neighbouring areas. Installation of telephone lines to benefit a certain area, which in turn benefit people along the road who might be not the really intended persons for the project.

Benefits are considered in SCBA even through they are ignored in assessing the monetary benefits to the project sponsors because they do not receive any monetary compensation from those who enjoy the external benefit created by the project.
For example if the government creates a Water Dam in a certain area then the relevant costs in SCBA will include

• Environmental pollution costs
• Formation of mosquito breeding grounds
• Number of plots lost by farmers etc

These costs should be included in SCBA because in such analysis all costs and benefits, irrespective to whom they accrue and whether they are paid for or not, are relevant.

However the main problem, which remains, is how to identify and quantify all possible external effects of a project, and to what extent or how far these external effects should be considered. In telephone industry, an incumbent company may invest in infrastructure which is very costly, but which can as well benefit the new entrants to the market without making substantial infrastructure. For example are the public telephone companies which invested heavily in infrastructure which in turn benefit new entrants. A regulator should be able to see the negative and positive externalities and regulate the market to create fair playing grounds for all parties.

3. Taxes and Subsidies
From the social point of view. Taxes and subsidies are generally regarded as transfer payments and hence considered irrelevant.

4. Concern for Savings
Private firms do not put differential valuation on savings and consumption.
In social point of view, the division of benefits between consumption and savings which leads to investment is relevant.

The dollar benefits served is deemed pure valuable than a dollar of benefit consumed.

Therefore SCBA reflect also the concern for savings and investment of society.

5. Concern for Wealth Distribution
The problem of inequalities in the distribution of income and wealth is very much present on LDCs.

Private firm does not bother how its benefits are distributed across various groups in the society, or in the firm.
The society on the other hand, is concerned about the distribution of benefits across different groups.

6. Merit Wants
Goals and preferences not expressed in the market place but believed by policy makers to be in the larger interest may be referred to as merit wants.
Merit wants are not relevant as far as private firms are concerned but they are very important as far as the society is concerned.

For example, the Government may prefer to promote an adult education, or polio vaccinations programmes for young children. In the same context the government may promote access to telecommunication in the rural areas but investors may find it to be very expensive. Under such circumstances the government should participate in the investment to reduce the loss which may be incurred to the investor. Such projects are better financed by the government or donor funds and investors should be requested to contribute on the running costs. This means that social costs should be shared between the government and the private sector. Such projects have long-term social and economic benefits.

SCBA Approaches
According to the literature there are basically two approaches for SCBA namely UNIDO APPROACH and Little – Merles Approach

1. UNIDO Approach
It was first articulated in United Nations, Guidelines for Project Evaluation. 1972.
It provides a comprehensive framework for SCBA in developing countries.

The rigour and length of this work created a demand for a condensed and operational load guide for project evaluation in practice.
In response the UNIDO came out with another publication, Guide to Practical Project Appraisal in 1978.

Therefore, the discussion on UNIDO approach was based on guide to practical project Appraisal.
Stages of UNIDO Approach

1. Calculate financial profitability of project as measured at market pries.
2. Obtain the net benefit of the project on savings and investments.
3. Adjust for the impacts of the project on savings and investment.
4. Adjust for the impact of the project on income distribution.
5. Adjust for the impact of project on merit goods and demerit goods whose social values differ from their economic values.

Measurement of financial profitability
This is concerned with the overall profitability of the projects. No interest at this stage is paid to the manner in which a project makes benefits available to owners or sponsors. In the project, owners expect returns from the project. The owners may take dividends while the lenders expect interest revenue and the government expect taxes or other benefits. Financial profitability can be well estimated by using project financial planning analysis.
In order to measure financial profitability of the project, you need the following information:

1. Cost of Project
This will represent the total of all items of outlay associated with a project which are supported by long-term funds. These costs may include land and site development, building and civil works, plant and machinery, engineering fees, margin money for working capital etc.

2. Means of financing
This deals with the sources of fund to meet the cost of project. The cost of project. might be financed by using share capital, term loans, Debenture capital, Deferred credit, IOU incentives sources etc.

a) Share Capital (Refer Module 2)
This is divided into two categories namely equity capital and preference capital.

• Equity Capital this is contribution made by the owners of the business. The owners are known as equity shareholders (ordinary shareholders).
• These equity shareholders enjoy the rewards and bear the risks of ownership. Equity capital does not carry fixed rate of dividend, however they do carry voting rights.
• Preference capital represents the contribution made by preference shareholders and they have got fixed rate of dividend but they have no voting rights.

b) Term Loan
Provided by financial institutions and commercial banks
This is a kind of credit which is extended for one to seven years.
• This loan is usually repaid in monthly or quarterly installments over its life rather than a single payment.
• These represent secured borrowings which are very important source for financing new projects expansion of existing projects, moderation of existing firms/projects and renovations.
• This loan is usually repaid in monthly or quarterly installments over its life rather them a single payment

c) Debenture Capital
• Debentures are instruments for raising debt capital.
• Debentures are document issued by a company containing an acknowledgement of indebtedness that need not give a change on the assets of a company.

Debentures are divided into two categories

• Non-convertible debentures: -
  • Which are typically debt instruments and they carry fixed rate of interest.
• Convertible Debentures:
  • There can be converted wholly or partly into equity shares.

Planning the means of Finance the following are considerations which should be put into the mind:

1. Regulatory Bodies and Financial Institutions
In same countries the proposed means of financing for a project must be either approved by regulatory agency or conform to certain norms laid down by the Government of financial institution.
These regulations

• Help to protect investors by imparting prudence to project financing decisions.
• Provide the norms to financial institution.

2. Key Business Considerations
These include control, cost, risk and flexibility.
There cost involve the cost of debt and cost of equity funds –See module 2.

The main issue here is to consider which source of fund is less costly and less risky.
Usually, cost of debt is lower than the cost of equity because interest payable is a tax-deductible expense, while dividends are payable to shareholders and it is not taxable..

Both business and financial risk are faced by the firm.

On the other hand, control is very important because promoters will require a financing scheme which enables them to maximize their control over the affairs of the firm given their commitment of funds to the project.

Financial flexibility refers to the ability of a project to raise further capital from any source it wishes to tap so as to meet the future financing needs. This is also is the ability of project to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.

Projects with a high degree of financial flexibility are better to be anabled to survive during bad times, to recover from unexpected setbacks, and to take advantage of profitable and unexpected investment opportunities.

Therefore financial flexibility maintains reserve-borrowing powers to enable it to raise debt capital to meet largely unforeseen future needs.