Public Investment Criteria: Financial and Economic Internal Rates of Return

Abstract

The main purpose of this paper is to develop an integrated framework of analysis to examine the points of departure of economic from financial analysis of projects. This framework is sufficiently general to encompass the characteristics of various sectors of an economy. Differences in project boundary, externalities and policy distortions together provide the raison-d'etre for economic analysis. Once this is recognized, the transition from financial to economic analysis is clear cut as indicated in the following important conclusions drawn from the paper. First, only in cases where there are no externalities, project boundaries are similar between financial and economic analysis, and competitive internal markets exist can FIRR be used as a proxy for FIRR. Second, when issues of project boundary and externalities become important, public intervention is likely. Consequently, the weight of project boundary and externalities in determining the EIRR becomes critical. Low FIRRs anc high EIRRs are likely in projects with significant externalities. However, a comparison of FIRR and 'EIRR' based or. financial profitability adjusted for price distortions and differences in project boundary may. in this case, provide some clues of relating financial price to willingness to pay. Third, in cases where issues of project boundary and externalities are known to be important but quantification and valuation of all benefits and costs are not possible, the project analyst will have little option but to estimate an FIRR. and indicate qualitatively that net benefits associated with differences in project boundary and externalities are likely to be positive. Fourth, the statement that whenever an FIRR can be calculated an EIRR can also be calculated is in general not correct. Even if an 'EIRR' associated with financial profitability adjusted for policy introduced distortions can be estimated, it may be meaningless as a proxy for economic viability if issues linked to project boundary and externalities are important. Fifth, the statement that the FIRR is a lower bound estimate for EIRR has no basis when issues of economic pricing, project boundary and externalities are important. Sixth, FIRR should not be used as a proxy for assessing economic viability even when full cost recovery including capital cost has been used to establish the pricing principle for the public utility undertaking the investment project under consideration.