The Project Appraisal
Practitioners’ Guide
Volume V
USAID/INDIA
REFORM PROJECT
COMPENDIUM WITH PRACTITIONERS’ GUIDE
State Fiscal Management Reform
USAID/India REFORM Project Compendium with Practitioners’ Guide: State Fiscal Management Reform
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Compendium Disclaimer:
The REFORM Project Compendium with Practitioners’ Guides is made possible by the support of the
American People through the United States Agency for International Development (USAID). The
contents of this compendium volume are the sole responsibility of the authors and do not
necessarily reflect the views of USAID or the United States Government.
Authors:
Professor Graham Glenday, Duke University; Professor G.P. Shukla, Duke University; Professor Joseph
Than, Duke University; Mr. Deepak Kapoor, REFORM Project; Mr. Arunabha Maitra, REFORM Project;
and, Dr. Robert Voetsch, REFORM Project.
In addition, officials from the state governments of Jharkhand, Karnataka and Uttarakhand provided
invaluable input to complete the sector-specific Guidelines.
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Volume V: The Project Appraisal Practitioners’ Guide
REFORM
Rationale, Objective & Terms of Reference
The REFORM Vision ……
"State governments have the necessary organizational structures, analytical tools
and decision-making processes, information sources and trained staff that enable
them to make better informed choices on a transparent and accountable basis
with respect to state public finances. Subsequently, this capacity is institutionalized
into the mainstream of state government practices to ensure the sustainability
of the effort."

The Rationale:
The starting point of the USAID/India Fiscal Management Reform Project (REFORM) is that the fiscal
distress seen at the state level in early 2000 was, to a large extent, a result of the systemic weaknesses
in state fiscal management (Box 1), including within the key departments of finance and planning. This
prevented forward-looking fiscal decision-making grounded in careful analysis and leading to good
governance. In short, the majority of Indian states needed better analytical capacity backed by
appropriate institutional infrastructure to formulate and implement good fiscal policy.
Box 1: Systemic Weaknesses in Fiscal Management
The systemic weaknesses found in fiscal management at the state level may be described as "inadequate":
• Technical know-how in modern fiscal management practices.
• Comprehensive, current information databases.
• Robust analytical tools and techniques that correspond to internationally accepted standards.
• Integrated management information systems and systematic approaches to the fiscal decision-making processes.
• Transparent, consistent and institutionalized fiscal practices, reporting systems, and structures that promote the
desired accountability for the effective and efficient mobilization, allocation and utilization of public funds.
Currently, therefore, many Indian states do not have the appropriate capacity
1
and the necessary
practices
2
to perform relevant, economic and statistical analyses (Box 2).
Box 2: Consequence of Systemic Weaknesses
As a consequence of the systemic weaknesses, most Indian states, for example, have inadequate fiscal management
expertise and institutional infrastructure to perform revenue and expenditure projections and distributional analysis,
assess multiplier and elasticity effects, and run policy simulation and develop alternative policy scenarios. This
includes their inability to establish strong links between budgetary outlays and program outcomes for efficient and
effective delivery of results, establish debt and investment frameworks to improve their quality and profile, and
conduct rigorous project appraisals to ensure selection of socio-economically viable projects.
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i.e., fiscal management skill-sets, tools and techniques and organizational structures.

2
i.e., consistent, transparent and accountable processes.
USAID/India REFORM Project Compendium with Practitioners’ Guide: State Fiscal Management Reform
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Given increasing decentralization and the continued significance of public finance in India, many state
governments will be required to assume greater responsibility for the design and implementation of
their own development strategies. As a result, their ability to strike the right balance between fiscal
policy, broad-based growth, and financial sustainability will be fundamental to promoting and sustaining
development across every sector of the state economy and, consequently, the nation as a whole,
especially in light of the new challenges posed by the opening-up of the Indian economy and state
finances getting substantially linked with market forces.
The Objective:
As a response, USAID/India's REFORM project (September 2003 - 2008) was designed to provide practical
hands-on "how to" skills transferal, based on international best practices, to strengthen fiscal analytical
expertise, structures and systems of selected Indian states. The objective was to help these states to
better plan and manage their public finances, especially in the light of the challenges they faced
following the 2000-01 fiscal crisis. Jharkhand, Karnataka, and Uttarakhand were identified as the three
REFORM partner states.
The specific objectives of REFORM were:
1) To improve "informed" decision-making within state (sub-national) governments;
2) To ensure that decision-making processes followed consistent and transparent principles, leading
to greater accountability; and,
3) To sustain the efforts by institutionalizing and mainstreaming the capacity built.
REFORM, therefore, was not designed to advise or guide Indian state governments
on specific policy decisions but rather to enhance their ability to evaluate and to
address crucial policy choices and implementation options, based on an
understanding of the environment - i.e., its potentials, its limits and its perceived
needs.
3
Terms of Reference:

Based on discussions with the respective partner states, the REFORM terms of reference were to help
enhance their fiscal management capacity in the following four (4) areas:
• Revenue Management Capacity – To help states undertake detailed analysis of revenue projections
and the implications of alternative tax policies and revenue choices. Interventions included:
Introduction of improved revenue forecasting methodologies, an Input-Output (I-O) framework
and macro-economic database. A practitioners’ guide was also developed along with hands-on
training to build state capacity in the above areas.
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Capacity-building as defined by the United Nations Center for Education and Development, (Agenda 21's definition, Chapter 37,
UNCED, 1992).
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Volume V: The Project Appraisal Practitioners’ Guide
• Expenditure Planning and Management Capacity – To help states improve quality and accountability
of expenditures. Interventions included: Introduction of an outlays to outcomes budgeting
methodology (i.e., program performance budgeting (PPB)) to help states’ prioritise the allocation of
public funds, improve program planning, monitoring and evaluation, increase transparency,
accountability, and consequently, the quality of public services delivery. A practitioners’ guide with
related software was developed and delivered. Structured/hands-on training was provided across
all levels and in almost all departments. Detailed public procurement guidelines were also
developed for two out of the three states.
• Debt and Investment Management Capacity – To help states to better document, track, analyze, and
manage debt, contingent liabilities and investments, in the medium to long term. Interventions
included structured and hands-on training as well as introduction of practical guides (with reporting
templates). Comprehensive debt datasets were developed and migrated into a database using the
Commonwealth Secretariat-Debt Recording and Management System (CS-DRMS) software.
• Project Appraisal Capacity – To help states improve appraisal and selection of socio-economically
viable capital projects. Interventions included: Training in the Harberger project appraisal technique
which involves financial, economic, social and stakeholders’ risks analysis. A Project Appraisal
practitioners’ guide with sector-specific guidelines was also developed and introduced to serve as
a desk reference.

To sustain and mainstream the above fiscal management reform efforts, four (4) institutional structures
were designed and supported:
• The Fiscal Policy Analysis Cell (FPAC) – To help states institutionalize continuous analysis of the
implications of policies, procedures and regulatory decisions on the fiscal health of the states. An
analytic unit supported by a team of dedicated and trained staff, with access to relevant and quality
data, tools and techniques was established.
• The Debt and Investment Management Cell (DMIC) –To help states identify, generate, and analyze
data and support more effective and prudent debt/investment decision-making. Similar to the
FPAC, an analytic unit supported by a team of dedicated and trained staff, with access to relevant and
quality data, tools and techniques was established.
• Project Unit (PU) – To help states offer a comprehensive range of services from project appraisal and
monitoring, to final end-of-project evaluation, a project unit was designed that would also help
promote public-private partnerships (PPPs).
• Administrative Training Institutes (ATIs) and State Institutes for Rural Development (SIRDs) – To help
state civil service training institutes (ATIs and SIRDs) train entry level and mid-career state civil
servants in fiscal planning and management, training courses; training materials and reference guides
were developed and provided.
USAID/India REFORM Project Compendium with Practitioners’ Guide: State Fiscal Management Reform
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The Final Products:
A project Compendium with Practitioners’ Guides was developed under REFORM to assist state
governments to implement necessary fiscal management practices in the areas of forecasting,
budgeting, tracking of debt and investment, and improving project appraisal techniques. Specifically,
these Guides were developed to function both as desk references for government officers earlier
trained under REFORM as well as training tools for strengthening capacity of new officers. For officers
not earlier exposed to the new fiscal practices, the Guides will need to be supplemented with additional
technical support or guidance.
The Compendium also includes a variety of case studies including the experiences of the three REFORM
partner states – Jharkhand, Karnataka, and Uttarakhand – with respect to the implementing the new
practices under REFORM.

“Fiscal Watch”, a virtual resource center, has also been designed and launched to provide a dedicated
site to promote greater thinking, collaboration, discussions, best practices and, exchange information
and post current data on the fiscal health (and related issues) of Indian states and India. The key feature
of “Fiscal Watch” is the dedicated discussion forums to facilitate interaction between fiscal practitioners,
both Indian and international (e.g., to provide a platform for finance secretaries, budget officers, revenue
officials, and researchers). In addition, there are numerous hyperlinks to related online resources such
The REFORM project may therefore be considered as four-by-four (4x4), consisting of four intervention
areas (expenditure, revenue, project appraisal, and debt and investment management) supported by
four institutional structures (FPAC, DMIC, PUs, and ATIs/SIRDs).
Fiscal Policy Analysis Cell (FPAC)
Debt & Investment Mgt Cell (DIMC)
Project Units (PU)
State Administrative Training Institutes (ATIs)
Improved Revenue
Management:
• Revenue Forecasting
• Macro-Econ Database
• Input-Out Tables
• Tax Analysis
Improved Expenditure
Planning & Management:
• Program
Performance Budgets
• Procurement
Guidelines
Improved Project
Appraisal:
• Project Appraisal
• Project Financing
Improved Debt and

Investment Management:
• Management of:
– Debt
– Contingent Liability
– Investment
– Credit Worthiness
Guidelines
REFORM: Four-by-Four
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Volume V: The Project Appraisal Practitioners’ Guide
as government websites, professional societies, consultancy opportunities, and training and education
providers.
To Conclude:
Despite spending large sums of money, governments and donors in many countries have been limited
in their ability to develop successful, sustainable programs due to the inadequacy of fiscal management
expertise and infrastructure. Such inadequacies prevent the productive absorption of funds. They also
prevent states from equipping themselves with the necessary fiscal shock absorbers to cushion them
against unexpected fiscal challenges - some arising out of discretionary, unplanned decision-making
and others as a result of increased globalization. More often than not, these unexpected challenges can
and have served as the tipping points, seriously affecting the fiscal condition of even fiscally healthy
states, as seen in India especially post 1995-96.
However, given the increasing recognition by state governments of the role of and need for improved
fiscal management capacity in Indian states' development process, and indeed for India as a nation, we
are confident that endeavors such REFORM will be sustained and further strengthened.
Madhumita Gupta, Team Leader REFORM, USAID/India

Table of Contents
Preface 15
Why Develop this Guidebook? 15
What is the Guidebook? 15

When to use the Guidebook? 15
Who should use the Guidebook? 15
How to use the Guidebook? 16
Section I: Project Appraisal Methodology 17
Part 1: Introduction 17
Purpose of the Project Appraisal Guidebook 17
The Targeted Users of the Guidebook 17
What is a Project? 17
Project as an “Incremental” Activity 17
Uncertainty and Contractual Arrangements 17
An Overview of the Guidebook 18
Part 2: Project Development and Approval Cycle 19
Project Development Cycle 19
Projects and State Development Plans 19
Concept or Identification Phase 20
Action Points in Project Identification 20
Problems in Project Identification 20
Sources of Project Identification 21
Preparation Phase 21
Policies and Procedures 21
Technical and Institutional Alternatives 21
Prefeasibility Phase 22
Marketing or Demand Module 22
Technical or Engineering Module 23
Environmental Module 23
Manpower and Administrative Support Module 23
Institutional Module 24
Financial Module 24
Economic Module 25
Social Appraisal or Distributive and Basic Needs Analysis 25

Nature of Distributive Analysis 26
Nature of Basic Needs Analysis 26
Use of Secondary Data in the Prefeasibility Phase 26
Feasibility Study and Financing Negotiations 26
Detailed Design 27
Project Implementation 27
Ex Post Appraisal and Evaluation 28
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USAID/India REFORM Project Compendium with Practitioners’ Guide: State Fiscal Management Reform
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Part 3: Project Evaluation Framework 30
Integrated Project Analysis 30
Financial Analysis 31
Investment Plan 32
Operating Plan 32
Financing Plan 32
Financial Attractiveness 32
Economic Analysis 33
Distributional Analysis 34
Risk Analysis 34
Part 4: Project Evaluation Framework: Schematic Diagram 36
Basic Facts 36
Project Outcomes 36
Part 5: Project Evaluation Criteria 39
Introduction 39
Time Dimension of a Project 39
Time Value of Money 39
Compounding 39
Discounting 40

The Net Present Value (NPV) Criterion 40
Internal Rate of Return (IRR) Criterion 42
Problems with the IRR Criterion 42
Benefit-cost Ratio (BCR) Criterion 46
The BCR Criterion 46
Part 6: The Financial Analysis of a Project 48
Introduction 48
Why a Financial Appraisal for a Public Sector Project? 48
Financial Sustainability 48
Distributional Impacts 49
Profitability 49
Financial Cash Flows: Concepts, Principles and Conventions 49
What is a Financial Cash Flow Statement? 49
Components of a Cash Flow Statement 50
Investment Plan 52
Data and Data Breakdown 52
Opportunity Cost of Existing Assets 52
Investment Financing 55
Operating Plan 55
Adjustment of Sales 55
Adjustment of Purchases 57
Adjustment for Changes in Cash Balance 59
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Volume V: The Project Appraisal Practitioners’ Guide
Working Capital 60
Accounting for Working Capital in the Cash Flow Statement 60
Estimation of Working Capital Requirements 60
Estimation of Income Tax Liability 61
Cessation of Project Operations 61
Land 62

The Financial Analysis from Different Points of View 63
The Owner’s Point of View 63
The Total Investment (Banker’s) Point of View 63
Budgetary Point of View 64
Other Perspectives 64
Can this Analysis be Applied to Social Sector Projects? 64
The Use of Consistent Prices in Financial Appraisal: Inflation Treatment 66
Interest Rate 66
Expected (Nominal) Exchange Rate 67
Incorporating Inflation in the Financial Analysis 68
Part 7: Financial Cost of Capital 71
Nominal Cash Flow Statement 71
Points of View in the Financial Analysis 72
Nominal Weighted Average Cost of Capital (WACC) 72
Consistency Check for the Two Financial Points of View 73
Numerical Example 73
Part 8: Risk Management 101
Sources of Risk in a Project 101
Market Risk for the Product 101
Foreign Exchange Risk 101
Government Policy and Politics 101
Natural Resources 101
Natural Disasters 101
Internal Risks to the Project 101
Risk of the Equity Holder 101
Debt Financing and Debt Service Capacity Ratios 102
Annual Debt Service Capacity Ratio (ADSCR) 102
Debt Service Capacity Ratio (DSCR) 102
Numerical Example 102
Decreasing the Interest Rate on the Loan 103

Decrease the Amount of Borrowing 103
Increase the Duration of the Loan Repayment 103
Bridge Financing 104
Risk Spreading and Pooling 104
Systematic Risk 105
Regression Analysis 105
Incremental Systematic Portfolio Risk 106
Mechanisms for Reducing the Costs of Risk 106
Capital, Financial and Futures Markets 107
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Contracting 107
Real Options 107
Project Finance 107
Capital Asset Pricing Model (CAPM) 107
Risk Allocation: Sources of Contracting Risks 108
Risk Shifting of Exogenously Generated Risks 108
Contracts that Restructure Intra-project correlations 108
Profit-sharing Agreement with Labor 108
Profit-sharing Agreement with Labor 109
Real Options 109
Part 9: Economic Externalities 110
Introduction 110
What is Economic Externality? 110
Environmental Externalities 111
Accounting for Environmental Externalities in Project Appraisal 111
Monopoly Externalities 111
Tax, Tariff, Subsidy Externalities 113
Tax and Subsidy in the Market of Nontraded Goods 113
Import Duty and Export Tax in the Market of Traded Goods 113

Foreign Exchange Externality 114
Accounting for the Foreign Exchange Externality into Economic Analysis 114
Economic Benefits Including Externalities 116
Economic Costs Including Externalities 116
Economic Externalities in the Capital Market and the Labor Market 117
Part 10: Estimation of Economic Prices of Tradable Goods and Services 121
Introduction 121
Tradable and Nontradable Goods 122
Estimation of Economic Prices at the Port: Adjusting for Trade Distortions and Foreign Exchange 122
Examples Showing the Calculation of Financial and Economic Prices 123
Estimating Commodity-specific Conversion Factors 126
Estimation of Economic Prices at the Project: Adjusting for Handling and Transportation Costs 127
Part 11: Estimation of Economic Prices for Nontradable Goods and Services 130
Introduction 130
Analyzing the Economic Benefits of an Output Produced by a Project in an Undistorted Market 130
Analyzing the Economic Cost of an Input Demanded by a Project in an Undistorted Market 131
Economic Prices for Nontraded Goods in Distorted Markets 132
Analyzing the economic benefits of an output produced by a project in a distorted market 132
Analyzing the economic costs of an input demanded by a project in a distorted market 133
Estimation of Economic Prices 136
Economic Price of a Nontradable Output with Adjustment for the Foreign Exchange Premium 139
Estimation of the Economic Price of Hotel Room Nights in Domestic Currency 140
Estimation of the Economic Price of an Intermediate Goods used as an Input of a Project 141
Estimation of the Economic Price of Bricks in Domestic Currency
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Volume V: The Project Appraisal Practitioners’ Guide
(Adjusting for Distortions in Markets of Clay and Oil) 146
Clay 146
Furnace Oil 146
Part 12: Estimation of Economic Prices for Goods and Services in Regulated Markets 148

Introduction 148
Economic Value of a Price-regulated Goods with Price Rationing 149
Economic value of a price-regulated Good with Quantity Rationing 150
Part 13: Evaluation of Stakeholder Impacts in Cost-benefit Analysis 151
Introduction 151
Distributive Analysis 151
Reconciliation of Economic and Financial Values of Inputs and Outputs 152
The Case of a Major Expansion in the Supply of a Nontraded Goods in an Undistorted Market 152
The Case of Nontraded Goods Sold into a Market with a Unit Tax 153
The Case of an Importable Input that is Subject to Tariff 154
Part 14: Institutionalizing the Project Appraisal Process 156
Institutionalization Process 156
Project Formulation and Appraisal Division 156
Objectives 156
Functions 156
Organization 157
Scope of Expenditure Finance Committee (EFC) 158
Explanation 158
Work Procedure of the Expenditure Finance Committee 158
Issue Government Order 159
Project Appraisal Implementation Road Map 159
Part 15: Summary of Project Appraisal Results and Recommendtion for Action 160
Annexures 165
Annexure 1: Economic Opportunity Cost of Foreign Exchange 165
Annexure 2: Economic Discount Rate 172
Annexure 3: Economic Opportunity Cost of Labor (EOCL) 175
Annexure 4: Pro forma for the New Projects to be Presented to EFC for Approval 181
Annexure 5: Government Order Pro forma 185
Annexure 6: Project and Program Appraisal in the Public Sector (Financial Analysis) 188
Annexure 7: Project and Program Appraisal in the Public Sector

(Economic and Stakeholder’s Analysis) 190
Annexure 8: Project and Program Appraisal in the Public Sector (Risk Analysis) 192
USAID/India REFORM Project Compendium with Practitioners’ Guide: State Fiscal Management Reform
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Section II: Sector Guidelines and Case Studies for Project Appraisal 17
Preface 199
Electricity Sector
Guidelines for Electricity Sector and Estimation of Regulatory Prices 203
Case Study: Hydroelectric Power Generation Project 208
Case study: Transmission Project 213
Road and Transportation Sectors
Guidelines for Road Projects 221
Case Study: Rehabilitation of Road Project 223
Case Study: Transport Sector Project 230
Irrigation Sector
Guidelines for Irrigation Sector 241
Case Study: Maskinala Irrigation Project 244
Water Supply Sector
Guidelines for Drinking Water Projects 255
Case Study: Kot Water Supply Project 259
Agricultural Extension Sector
Guidelines for Agricultural Research and Extension: Seed Production Project 267
Case Study: Seed Production Project 270
Housing Sector
Guidelines for Housing Sector Projects and Programs 277
Case Study: Residential Accommodation for Government Employees 280
Tourism Sector
Guidelines for Tourism Projects 287
Case Study: Tourism Development Project 289
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Volume V: The Project Appraisal Practitioners’ Guide
Biomedical Waste Management
Guidelines for Medical Waste Management Project 301
Case Study: Biomedical Waste Management 303
Education and Health Sectors
Guidelines for Social Sector Projects: Education and Health Projects 311
Tables
Part 1: Introduction 17
Table 1: Public Reforms on Investments (as a % of GDP)
Part 2: Project Development and Approval Cycle 19
Table 2: Indian States Capital Revenues (as % of GSDP)
Part 3: Project Evaluation Framework 30
Table 3.1: Key Characteristics of Financial Analysis of Self-financing and Nonself-financing Projects
Part 5: Project Evaluation Criteria 39
Table 5.1: Time Profile of Net Cash Flow for Project B
Table 5.2: Project Net Present Value Analyses
Table 5.3: Project Benefits Cost Ratio Analysis
Part 6: The Financial Analysis of a Project 48
Table 6.1: Organizations of Variables in a Financial Cash Flow Statement
Table 6.2: Investment Plan for a Hypothetical Water Supply Project
Table 6.3: Operating Plan for a Hypothetical Water Supply Projects: (A Few Years Only)
Table 6.4: Cash Flow Analysis
Table 6.5: Overall Investment Analysis
Table 6.6: Annual Cost Analysis
Table 6.7: Cash Flow Analysis
Table 6.8: Summary of Cash Flow Statement from Different Points of View
Part 7: Financial Cost of Capital 71
Table 7.1 Depreciation Schedule for the Machinery
Table 7.2: Income Statement without Debt Financing (in INR)
Table 7.3: Total Investment Point of View (TIP) Cash Flow

Table 7.4: Loan Schedule
Table 7.5: Income Statement with Debt Financing
Table 7.6: Cash Flow Statement, Equity Point of View
Table 7A.1: Project XYZ Financing
USAID/India REFORM Project Compendium with Practitioners’ Guide: State Fiscal Management Reform
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Table 7A.2: Project XYZ Cash Balance
Table 7A.3: Cash Balance with 25% Inflation
Table 7A.4: Accounts Receivable
Table 7A.5: Accounts Payable
Table 7A.6: Nominal Interest Rate of 5 percent
Table 7A.7: Nominal Interest Rate of 21.25% percent
Table 7A.8: Comparison of Real Cash Flow
Table 7A.9: Interest Expense
Table 7A.10: Project XYZ, Depreciation Allowance
Table 7A.11: Inventory and Cost of Goods Sold – FIFO
Table 7A.12: Inventory and Cost of Goods Sold – LIFO
Table 7B.1: Values and Probabilities for the Output Price: with Equal Possibilities
Table 7B.2: Values and Probabilities for the Output Price, with Equal Probabilities
Table 7B.3; Calculation of the Variance of the Output Price in Table 7B.1
Table 7B.4: Calculation of the Variance of the Output Price in Table 7B.2
Table 7B.5: Values and Probabilities for the Output Price, with Unequal Probabilities
Table 7B.6: Cumulative Probabilities for Step Distribution
Table 7B.7: Calculation of the Covariance of the Output Price and Quantity
Table 7C.1: Inflation Index and Nominal Price Profile
Table 7C.2: Annual Revenues and Accounts Receivable
Table 7C.3: Nominal Cash Flow Statement
Table 7C.4: Sensitivity Analysis of the Quantity of Output on the PV of the Net Cash Flow
Table 7C.5: Sensitivity Analysis of the Initial Output Price on the PV of the Net Cash Flow
Table 7C.6: Sensitivity Analysis of the Accounts Receivable on the PV of the Net Cash Flow

Table 7C.7: Sensitivity Analysis of the Expected Inflation Rate on the PV of the Net Cash Flow
Table 7C.8: Sensitivity Analysis of the Quantity of Output and the Initial Price in Year 0 on the PV of the Net
Part 8: Risk Management 101
Table 8.1: Annual Debt Service Capacity Ratio (ADSCR)
Table 8.2: Annual Debt service Capacity Ratio (ADSCR) with Lower Interest Rate
Table 8.3: Annual Debt Service Capacity Ratio (ADSCR) with Lower Amount of Loan
Table 8.4: Annual Debt Service Capacity Ratio (ADSCR) with Longer Duration for Loan Repayment
Table 8.5: Annual Debt Service Capacity Ratio (ADSCR) to Determine Viability of Bridge Financing
Table 8.6: Statistics for Oil Exploration for a Single Company
Part 11: Estimation of Economic Prices for Nontradable Goods and Services 130
Table 11.1: Relationship between Market Prices and Demand and Supply Prices with Various Types of Distortions
Part 15: Summary of Project Appraisal Results and Recommendtion for Action 160
Table 15.1: Summary of project Appraisal Results
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Figures
Part 4: Project Evaluation Framework: Schematic Diagram 36
Figure 4.1: Project Parameters: The Utility Authority Owns the Power Plant
Figure 4.2: Project Parameters: Independent party owns the Power Plant
Figure 4.3: Economic Analysis
Figure: 4.4: Distributive Analysis: The Utility Authority Owns the Power Plant
Figure 4.5: Distributive Analysis: Independent party owns the Power Plant
Figure 4.6: Distributive Analysis: Independent party owns the Power Plant
Figure 4.7: Risk Analysis
Part 6: The Financial Analysis of a Project 48
Figure 6.1: Different Financial Project Profiles
Figure 6.2: Schematic Representation of the Relationship between Sales and Cash Receipts
Figure 6.3: Expenditure Analysis
Figure 6.4: The Cash Conversion Cycle
Part 7: Financial Cost of Capital 71

Figure 7B.1: Graph of Uniform Probability Distribution
Figure 7B.2: Cumulative Uniform Probability Distribution
Figure 7B.3: Insert Graph for Custom Step Distribution
Figure 7B.4: Insert Graph for Triangular Distribution
Figure 7B.5: Graph for the Normal Distribution
Figure 7B.6: Graph for the Cumulative Normal Distribution
Part 9: Economic Externalities 110
Figure 9.1: Monopolistic Market
Figure 9.2: Relationship between tax and Commodity Price and Quantity
Figure 9.3: Relationship between Subsidy Commodity Price and Quantity
Figure 9.4: Distortion due to an Import Duty
Figure 9.5: Distortion caused by an Expert Tax
Figure 9.6: Relationship Between Project Social Cost and Commodity Pricing and Quantity
Figure 9.7: Relationship Between Project private Cost nad Commodity Pricing and Quantity
Part 11: Estimation of Economic Prices for Nontradable Goods and Services 130
Figure 11.1: Economic Benefits of a New Project in an Undistorted Market
Figure 11.2: Economic Cost of an Input Demanded by a Project in an Undistorted Market
Figure 11.3: Economic Benefits of a New Project in a Distorted Market
Figure 11.4: Economic Cost of Input Demanded by a Project in a Distorted Market
Figure 11.5: Economic Benefits of Project Output (No Distortions)
Figure 11.6: Economic Benefits of Project (Tax on Output)
USAID/India REFORM Project Compendium with Practitioners’ Guide: State Fiscal Management Reform
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Part 12: Estimation of Economic Prices for Goods and Services in Regulated Markets 148
Figure 12.1: Excess Demand for Electricity in a Regional Electricity market
Figure 12.2: Valuation of Added Electricity Supply in a Market with Excess Demand that is Removed by Price
Rationing
Figure 12.3: Valuation of added Electricity Supply in a Market with Excess demand that is Removed by Quantity
rationing (Q-rationing)
Part 13: Evaluation of Stakeholder Impacts in Cost-benefit Analysis 151

Figure 13.1: Financial and Economic values for Production of Nontraded Goods in Undistorted Markets
Figure 13.2: Financial and Economic values for Production of Nontraded goods with a Unit Tax
Figure 13.3: Measuring Distributive Impact from financial and Economic Values of Inputs with Tariffs
Boxes
Part 7: Financial Cost of Capital 71
Box 7.1: TIP Cash Flow Exclusive of Tax Savings
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Volume V: The Project Appraisal Practitioners’ Guide
Why Develop this Guidebook?
The purpose of this Guidebook is to help an Indian State Government implement the use of
international best practices of Project Appraisal while approving a public sector project.
Specifically, this Guidebook has been developed to assist state governments to develop and
evaluate investment projects to promote economic and social well-being. It describes how public
sector investments should be evaluated so that they may be taken from the idea stage to the
implementation phase in a successful manner. These themes will be addressed under three
headings: financial, economic, and distributional analysis of a project.
By their very nature, investment projects involve benefits and costs over a number of years into the
future. Market prices and project outcomes cannot be predicted with certainty. In addition, technical
difficulties and delays in implementation frequently result in cost and time overruns. Given this
uncertainty, account must be taken of a project’s risks and the costs that these risks create. Risk
analysis, and how to reduce and manage risk through the use of contracting, and other risk mitigation
methods, will constitute the fourth Section of the Guidebook.
What is the Guidebook?
The Guidebook is a supplement to training of those employees who are not familiar with the
methodology of project selection using Net Present Value (NPV) criteria. It helps employees of the
operating departments understand the methodology for viable project selection. The Guidebook
contains an introduction to project appraisal techniques, a detailed discussion on financial,
economic, stakeholder and risk analysis, and some practical recommendations on how to proceed.
When to use the Guidebook?
Once a state government has decided to adopt this methodology for approving the projects, the

state can use the Guidebook as a desk reference.
Who should use the Guidebook?
This Guidebook is intended for a number of users in these states. First, it serves as a guide to the
public sector managers responsible for making public sector investment decisions. This group
includes not only project analysts and decision makers within the ministries of planning and finance,
but also those employed in the line ministries, and government departments and agencies that are
involved with the formulation, evaluation and implementation of projects. Second, the Guidebook is
meant to be used for training purposes by the training institutions to educate and train the future
managers in these states. Finally, it provides an assurance to the international development and
lending institutions that the funds provided to the states will be spent in a responsible and
productive way.
Authors’ Note
USAID/India REFORM Project Compendium with Practitioners’ Guide: State Fiscal Management Reform
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The Guidebook is intended for a number of users within the State Governments. First, it serves as a
guide to the public sector managers responsible for making public sector investment decisions.
This group includes not only project analysts and decision makers within the ministries of planning
and finance, but also those employed in the line ministries, and government departments and
agencies that are involved with the formulation, appraisal and implementation of projects. Second,
the Guidebook is meant to be used for training purposes by the training institutions to educate and
train the future managers in these states. Finally, it provides an assurance to the international
development and lending institutions that the funds provided to the states will be spent in a
responsible and productive way.
How to use the Guidebook?
The Guidebook serves as a baseline tool to assist state governments to implement necessary fiscal
management reform. The compendium includes guidelines for on-the-ground implementation of
international best practices by state officials in the areas of forecasting, budgeting, tracking of debt
and investment, and improved project appraisal. These guidelines have been developed with the
aim of serving both as desk references for government officials already trained in the respective
fiscal competency as well as training tools for structured capacity-strengthening programs. For

officials not already exposed to the fiscal practices introduced under REFORM, the guidelines will
need to be supplemented with technical support or guidance.
Current Project Appraisal Status in India
The Subnational governments in India practically without exception have registered either
declining or stagnant own nontax revenues as percentage to their respective GSDP over the years.
While decomposing the aggregate own nontax revenues of all States, the two sources — i.e.,
receipts from economic services and profits and dividends provide a very dismal picture as given:
Table 1: Public Reforms on Investments (as a % of GSDP)
2003-04 2004-05 2005-06 2006-07 (RE) 2007-08 (BE)
Dividends and Profits as % of GDP 0.01 0.01 0.16 0.01 0.01
Receipts from Economic Services as % of GDP 0.60 0.73 0.60 0.59 0.64
Total Own Nontax Revenue as % of GDP 1.39 1.51 1.34 1.34 1.30
The factor contributing to this situation has been ,inter alia, the low or negative return from
investment of the projects of the States. Returns of the projects almost invariably did not cover the
debt servicing liability nor it were near the recovery of the O&M cost. In the past, before deciding in
favor of launching a project, seldom there had been systematic project appraisal at the State level.
This, in turn, has added to cumulative adverse impact on the deteriorating fiscal health of the States
and the burgeoning fiscal deficits. Thanks to the buoyancy of the economy and the improvement in
the tax revenue front, the States are now in better fiscal position though the nontax revenues are
still a matter of concern and need urgent attention.
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Volume V: The Project Appraisal Practitioners’ Guide
With the improvement in overall fiscal health, the States in aggregate would be able to create a
financial space on the revenue account to contribute to the capital outlays, which is showing a rising
trend as shown in Table 2.
Table 2: Indian States Capital Revenues (as % of GSDP)
2003-04 2004-05 2005-06 2006-07 (RE) 2007-08 (BE)
Capital Outlay in INR crores 52426 61559 77559 104942 118796
Capital Outlay as % of GDP 1.90 1.96 2.17 2.53 2.61
Barring a few, the States have enacted FRBMA. As such, it is expected that States will be able to

eliminate the revenue deficits by 2008-09. The surplus generated on revenue account and the entire
borrowed amount would now be spent on financing the increased capital outlay for creation of
assets. However, the States have stipulated to keep the fiscal.
Deficit within 3 percent of the GSDP from 2008-09 onwards as per the FRBMA. Besides, following the
recommendations of the Eleventh Finance Commission and the Twelfth Finance Commission, the
Ministry of Finance has been imposing global annual borrowing cap to the States which is kept in
view by the Planning Commission of India while finalizing the Annual Plan size and its scheme of
financing of the States. Therefore, the fund available to the States to finance the developmental
projects has been limited in comparison to the need and hence calls for judicial steps by informed
decision making for selection of projects.
While recommending the need for better expenditure management of the States, the Twelfth
Finance Commission observed “Issues of efficiency require consideration whether the same
outcome can be achieved at lower costs and whether the same costs can produce better outcomes.
Thus, the management of public expenditures should be guided by economy, efficiency and
effectiveness. “According to the Approach Paper of the Eleventh Five-Year Plan, the Planning
Commission is considering making it a firm condition that all proposals submitted to it must require
sufficient benchmarking before approval. It also plans to strengthen its evaluation capacity by
involving research institutions and civil society organizations which have the capability of
undertaking rigorous evidence based evaluation. State governments, therefore, has to put in place a
system for initiating measures for appraisal, monitoring and evaluation of plan programs as a
counterpart action.
As per the expenditure assignments, the Indian States are responsible for most infrastructure
services except for telecommunication, civil aviation, railways and major ports. Inadequate
investment in infrastructure has constrained the growth and development of the States. The States
would need to strengthen their finances through fiscal, structural and institutional reforms which
would enable them to release adequate budgetary resources as also enable them to mobilize funds
more easily for financing infrastructure. To generate sufficient fund, the States are utilizing two routes
namely Public-Private Partnership (PPP) and Externally Aided Projects. In both the cases, careful
USAID/India REFORM Project Compendium with Practitioners’ Guide: State Fiscal Management Reform
22

planning is required to avoid loss of scarce resources. The States, under the circumstances, would be
requiring utilizing the techniques of the project appraisal for informed decision-making.
With bulk of the responsibilities pertaining to public expenditure on social services placed in the
domain of State Governments, it is widely recognized that the level of social sector expenditure has
important implications for the level of human development. As per the millennium development
goals prescribed by the United Nations (UN) in 2000, the countries need to achieve targets
particularly relating to social sector by 2015. As most of the millennium development goals relate to
social sector, the States have a major role to play in reaching the targets by adequate investments.
Contrary to the traditional belief that if a social sector project is economically sound, its financial
analysis is of little consequences, the financial cash flows are crucial for projecting the cash position
of the project in the future and determining if and when cash injections from the State budget would
be necessary. If the project can’t be implemented due to paucity of fund and lack of advance
planning, there is not going to be any economic benefit from the project. Thus, it is expected that
the use of project appraisal techniques would be prevalent at the sub-national level as the Indian
States would go for increasing social sector investments.
An Overview of the Guidebook
The Guidebook has been divided into three Sections.

Section I will focus on the theory and
methodology of project development and appraisal (cost-benefit analysis); examples will be
provided to illustrate many of the points.
Section II of the Guidebook will present sector specific guidelines mainly for conducting the
economic analysis of selected sectors. The key sectors that have been included are:
• Electricity;
• Road and transportation;
• Irrigation;
• Water supply;
• Agricultural extension;
• Housing;
• Tourism;

• Biomedical waste management; and
• Education and health.
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Volume V: The Project Appraisal Practitioners’ Guide
Finally, Section III will consist of

case studies developed by the participants on how to apply the
theory and methodology from Section I and Section II to real-life projects from the selected sectors
of GOAJ.

The spreadsheets of the case studies will be put as the Annexures.
Users of this Guidebook will hopefully go back and forth between the theory and the case studies to
gain a thorough understanding of how to apply the principles of project evaluation to the analysis of
investment opportunities in the public sector.

Project Appraisal
Methodology
Section I