One of the key objectives of project appraisal is to select good projects
and stop bad projects. More specifically, the analyst should approve
projects that are good from the economic point of view. Simply stated,
good projects increase the wealth of a country and bad projects decrease the
wealth of a country. The economic point of view (also known as the
society's point of view) takes into account the actual benefits to the
stakeholders of the project and the actual value of the resources that are
required by the project. When there are distortions in the economy, the
discrepancies between the economic cash flows and financial cash flows
may be huge. A project is good from the society's point of view if the net
(economic) Gash flow, discounted by the economic discount rate, is
positive.
We can use a simple 2 by 2 matrix (see below) to summarize the decision
rules for assessing a project. If the project is good from both the financial
and economic points of view, the decision is simple: we should approve the
project. (Upper left cell of the matrix). Similarly, if the project is bad from
both the financial and economic points of view, the decision is simple: we
should reject the project. (Lower right cell of the matrix).
The decision rules for the other two cells are more problematic. In the
lower left cell of the matrix, the project is bad from the economic point of
view, and we should reject the project. However, stakeholders who have a
vested financial interest in the project may exert tremendous pressure to
approve the project. In the upper right cell of the matrix, the project is good
from the economic point of view, and we should implement the project.
However, since the financial analysis is bad, it may be difficult to finance
the project, especially if the government budget does not have the financial
resources.
Using the simple 2 by 2 matrix to pigeonhole a project can go a long way
in improving project selection.
