COST-BENEFIT ANALYSIS OF AN INDUSTRIAL PROJECT
lable 9.3 Valuation at Efficiency Prices of Current Costs and Stocks
9.6 Effects of Changes in Financing
The objective of this section is to discuss the consequences of changes in financing on profitability at efficiency prices and on distributional effects.
Consider first a change in the financing of fixed investment resulting in a reduction of (the present value of) long-term financing, which is compensated by an increase in internal funds. The effect of this change will be to reduce the present value of net income for the project's owners since the real interest rate is below the discount rate. This reduction in income will be compensated by an increase in the income of those who receive loans not granted to the project. This will affect the distribution of income changes from the project without any impact on its profitability at efficiency prices.
Secondly, the case may be considered in which the foreign suppliers of machinery provide all the long-term credit. In order not to introduce numeri-cal complications, it will be assumed that credit conditions are the same.
Table 9.12 shows the present value of the corresponding flows, considering that the suppliers' credit is "tied" to the project.6
The project receives a present value of $86,000 to finance the purchase of imported machinery and equipment. The loan is provided by the "foreigner,"
who receives the present value of the respective repayment flow. Since the machinery was valued at its c.i.f. price times the APRFE when investment costs were being considered, the credit received must be regarded as foreign exchange income and, consequently, also corrected by the APRFE. Thus, what is actually paid for the machinery is its c.i.f. value (105,000), less the loan received (86,000), plus repayment of it (48,000), all multiplied by the APRFE, i.e.
Now, as cost-benefit analysis takes into account the CVs of the effects on
"nationals," the loss to the "foreigners" must not be shown as a project
6, Financing would not be received if the project were not carried out, i.e. income and repayment of the loan are flows of foreign exchange attributable to the project.
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"cost." In other words, one of the benefits of the project would be, in this case, obtaining a 38,000 transfer in foreign exchange from the foreigner, whose value at efficiency prices is7
Consequently, the effect of the financing will be recorded in the cost-benefit analysis accounts as shown in Table 9.13 and the total effects of the project on nationals will then be those shown in the column Total at Efficiency Prices.
This table is the same as 9.10, except that the column Foreigners has been included, and the Financing row has been replaced by the results obtained in Table 9.12. We can now see that the present value of the project at efficiency prices has increased, compared to the case with long-term financing from national sources (Table 9.10), in the value at efficiency prices of the foreign exchange transfer received from the "foreigners" (38,000 X 1.1 =41,800).
Finally, we should consider the possibility of the project being carried out with foreign investment. For example, let us consider the case described in Table 9.14, in which total fixed investment will be financed by long-term loans granted by the National Bank (86,000) and the remainder by contribu-tions from national (60%) and foreign (40%) shareholders.8 The latter will make their contribution in foreign exchange and will receive profits in propor-tion to their contribupropor-tions, i.e. 40%. The effects of this financing on profit-ability at efficiency prices and the distributional effect can be recorded by including an additional column in Table 9.10 for foreign investors, as shown in Table 9.15. To begin with, we would assume that the foreign investors bring their share in cash and send the income obtained from their investments abroad as they receive it. Thus, they deposit foreign exchange for a domestic currency equivalent of $23,600. In addition, over the useful life of the project, they remit the capital invested that they have recovered, plus profits equivalent to a profitability rate equal to the discount rate, so that at the end of the useful life of the project they will have remitted a present value equal to their original investment. Now, as the project's profitability is greater than the discount rate, the foreign investors receive (and remit) 40% of these "excess profits". As both the capital contribution and subsequent remittances consti-tute flows of foreign exchange, these flows have been corrected by the APRFE and the corresponding transfers allocated to the Government. Note that, assuming that the change in the source of financing has no effect on
7. The fact that the "transfer" could be compensated by a higher price for equipment or by payments for technology, does not change this because these payments have already been entered as project costs.
8. The reader should keep in mind that working capital will be financed by short-term credit from the national banking system.
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Table 9.13 Distribution of Income Changes from the Project When Long-Term Financing Is External and
"Tied" to the Project (ln$) Source: Tables 9.10 and 9.12.
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Table 9.14 Financing the Project with Direct Foreign Investment (InS)
Source Longterm Credits National Shareholders Foreign Shareholders Total
Amount 86,000 35,000 23,600
145,000
Percentage
59.3 24.4 16.3 100.0
production and costs, the result is a reduction in benefits at efficiency prices.
This reduction is equal to the share of foreign investors in the "excess profits"
of the project multiplied by the APRFE.
It could be argued that the investors would not remit all of their income but would reinvest at least part of it instead. Let us assume initially that a certain sum / is invested for a year at profitability rate after taxes q, and that after-wards it will be remitted. Consequently, instead of remitting /, the foreign investor remits
one year later. The present value of this remittance (Rt +,) will be
in which it can clearly be seen that the present value of the remittance at t +1 will be equal to what was not remitted at t when private profitability q is equal to the discount rate. If q were greater than d, the present value of the future remittance would be even greater than the present one and this would even further reduce the benefits at efficiency prices.9 When reinvestment takes place at profitability q lower than the discount rate, it will reduce the foreign exchange cost of remittances. Given the unlikelihood of this situation for plausible discount rate values, the criterion followed in Table 9.15 appears conservative.
Although the aim is not cost-benefit analysis of direct foreign investment, the example given here may cast light on some key variables to be borne in mind during the negotiating process that normally precedes an investment from abroad.10 Firstly, there is the problem of the so-called "transfer prices"
in international transactions. If that were the case, it is obvious that the
9. The total effect of re-investment on benefits at efficiency prices will also depend on its profitability at efficiency prices.
10. The interested reader may consult Sen (1971), Weiss (1980) and Kumar (1984).
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Table 9.15 Distribution of Income Changes from the Project Financed with Foreign Capital Source: Tables 9.10 and 9.14.
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project's purchases or sales should be valued at such prices and not at the
"world market" prices, since it is the former that determine effective flows of foreign exchange. Secondly, there is the problem of the valuation of the equipment that may constitute the capital contribution. It is logical to expect the foreign investor to try to overvalue it, since it is the book value (and not the real market value) that becomes the legal basis for the distribution of private profits from the project. Finally, in the example shown, it can clearly be seen that an important part of net income to investors comes from the transfers implicit in financing, this point being of greater importance the lower the real interest rate and the greater the proportion of financing from the national banking system.