Investment Project Design: A Guide to Financial and Economic Analysis with Constraints

Introduction

Accumulating capital assets and applying them to provide future benefits is a practice that dates from antiquity. Over 250,000 years ago, ancestors of our species Homo sapiens invested their time and energy to fashion simple tools to improve the quality of their lives. Yet, even today, how capital resources are applied—decisions about when, where, and how they should be committed—presents its challenges and does not always produce expected results.

The central theme of this book—designing the project to be compatible with its operating milieu so that it is profitable and sustainable while providing goods and services demanded by clients—derives in part from our many years as consultants to industries around the world, where we have witnessed an inordinate quantity of idle and rusting, sometimes never used, capital facilities, almost invariably the result of poor planning. With about 90,000 failures occurring annually in the relatively propitious U.S. business environment alone, it's clear that investing has always been a hazardous undertaking. Our planet is littered with remnants of investment ideas gone awry, projects that failed mainly because some critical design factor was improperly assessed.

Aside from the imponderable external factors that can sweep aside the best-laid schemes o’ mice and men, such as political and economic upheavals, one of the main deficiencies in project planning is that there is usually not enough of it, with decisions often made on the basis of anything from intuition to inadequate analysis. The recent meltdown of the financial sector in the United States and around the world is symptomatic of worldwide economic strains that are inimical to the interests of capital investors. We believe that the approaches we provide for designing, analyzing, and appraising a project can increase confidence in the investment decision in the minefield of the contemporary investment environment. Preinvestment study of appropriate breadth and depth, using these guidelines, vastly improves chances for a successful outcome.

A second motivation for the book involves potential benefits of a more holistic view of a project's business environment than has been the case traditionally. Benefits for private and public investors are ordinarily measured against corporate financial goals and objectives. As lines of demarcation between private and public enterprise are blurred in the global economy through subsidies and other public support to major enterprises, and as some enterprise is either totally or partially nationalized, benefits can be additionally measured from the perspective of society—benefits to citizens from public investment and conformance with public goals of private investment—and at the same time enhance prospects for successful investment if project outcomes complement overarching social goals as enunciated by administrative, legislative, and judicial decision makers. We attempt to show how the economic perspective—a much broader view of the enterprise environment than is traditionally considered by investors—reduces risk and enhances prospects for a successful enterprise. This theme has been developed comprehensively in Chapter 5.

Our intention is to provide guidelines for steering along the hazardous road to success faced by private and public investors and their collaborators. While others have addressed the subject, we propose a more comprehensive framework of analysis for any project involving capital investment—large or small, in private and public sectors—one that clears up a number of important misconceptions about financial aspects of design and appraisal, and that aligns the project more compatibly with features of its operating environment than has heretofore been the norm.

Unanticipated impediments to the success of investment projects have included mismatches between internal characteristics of the enterprise, its personnel, and other project needs, and external aspects of the operational setting such as market dynamics, supply constraints, or environmental impacts. Often there is a failure to consider alternatives that would constitute more profitable applications of the time, energy, and other resources applied to the contemplated project.¹

Maintenance and improvement of current material standards of living around the world requires new investment. In fact, at both macro (economy) and micro (enterprise) levels, new investment is needed just to maintain the current level of production capacity, which is diminished by technological obsolescence over time. Capital is also needed to accommodate advances in technology and for improving efficiency of existing production units. The question of whether a project is worthy of investment takes on ever-greater significance as capital accumulation for new projects is impeded by consumption demands of a growing population and by reticence of prospective investors and lenders in the face of increasing global uncertainties (e.g., depletion of critical resources and political instability).

An investment project becomes part of the economic, social, and ecological system within which it is intended to function and prosper. It affects the preexisting system of supply and demand and thereby alters its characteristics. Project success depends upon the degree of satisfaction that it provides to sponsors and collaborators, and also to the wider community that provides its market, its workers, and those whose lives are affected by its presence. A useful analogy for analyzing the relation between the project and its operational setting is the strategy of a biological organism seeking to survive and grow in its habitat.² The enterprise seeks to earn its living by forging a useful link between resources and consumers, while at the same time fulfilling its own objectives. It has internal characteristics that interact with components and systems in the operational setting. Its health and well-being depend upon compatibility with friendly forces and building defenses against those that are hostile.

As the project faces the general hazards of doing business, producing goods and services for public consumption, one design aspect too often overlooked is the fact that even in situations where the project is designed for finite life, the investment milieu of which the project is a part has no temporal boundary. In other words, benefits in the form of capital accumulation resulting from the project are generally intended for reinvestment: Culmination of the project after successful operations will provide opportunities to consider new projects. For this reason, even from the perspective of capital accumulation, the issue of sustainability is relevant. Successor opportunities in future reinvestment rounds will demand resources, so it is prudent to design the project so that it relies to the maximum extent on sustainable consumption.³ Many studies show that it is not only environmentally beneficial but also good business to investigate the benefits of renewable, recycled, reduced, and reused resources in both the manufacturing process and in goods and services produced for industry and for public consumption.

Capital investment has not only shaped the modern world, but undoubtedly has contributed much to public welfare around the globe. Events of the early twenty-first century have demonstrated that the system of capital allocation is far from perfect. Excesses in capital markets have caused enormous disruptions in the global economy, which may never regain the footing that existed prior to the onset of massive defaults in credit markets.

Although the proximate cause of the disruption appeared to be unprecedented wide-scale risky behavior of market participants, including excessive leveraging, a more fundamental explanation lies in the strains that existed in the global economy. The world's wealthiest country continued to pile up massive trade and fiscal deficits that were being financed and otherwise accommodated by the rest of the world, a situation that was clearly unsustainable. Europe was striving to integrate countries with widely disparate political structures and standards of living into an economic union. Asian countries were struggling to apply their newfound export wealth to transition into well-rounded, industrialized economies. All of this in the face of declining stocks of fossil energy, which has supported an aura of prosperity in the industrialized countries for over a century.

Aside from macroeconomic policies (or rather, the lack of them) that led to the disaster, clearly the declining fortunes of industrial enterprises throughout the world were indicative of widespread miscalculations at the micro, or enterprise, level. Planners of investment projects apparently failed to take into account the macroeconomic forces that would overwhelm the management capacities of their organizations. Circumstances and events external to these enterprises were apparently not sufficiently investigated and their consequences not adequately considered in their plans so that calamity could be averted.

This work is an attempt to provide, for sponsors of investment projects in the public or private sector, suggestions for improving the quality of their investment decisions. Analysis of socioeconomic impacts leads to better use of scarce resources and, concomitantly, more balanced economic development. For this reason, a more extensive and intensive investigation of both internal capacities and features of the external project environment is proposed, with details of how to execute the design and analysis of the project so that the investment decision is predicated on a sound footing of information and risk assessment. Project implementation is also covered, so that the hazards of delays in start-up and the risk of cost overruns are averted.

The methods described herein are relevant to the design, analysis, and appraisal of industrial, commercial, and infrastructure investment projects in private and public sectors. They are applicable to revenue-generating and nonrevenue projects, as well as projects of virtually any scale.

This volume is structured somewhat differently from others on the subject. It is intended more as a guide to project design and analysis rather than to provide a definitive framework for conducting an investment study. Design/study is presented as a continuous process, rather than consisting of discrete stages, to conform more closely to practice. Mobility of production factors, particularly capital and labor, is more important than ever to take into account. Project design is necessarily less tidy than in the past, responding to increasing complexity of doing business in most parts of the world.

Confronted with resource constraints, global competition, and an increasingly crowded world, investment analysis demands greater attention to the wider domain⁴—the operational environment, including infrastructure, beyond the edges of the project proper and its commercial setting—which is a major theme of this work. The proposed methods of design and analysis are considered to be applicable in virtually any investment environment, in both industrialized and developing countries.

There is a tendency to cloud distinctions between the project's components and characteristics, its impacts and constraints, as either internal or external. It is difficult to conceive of any project feature that is purely within one or the other category. A decision to appoint a manager cannot be totally separated from the availability of personnel within the population, or from the institutions that provided his training and experience. The terminology employed (e.g., internal) is a way of conforming to familiar semantics while at the same time alluding to the unavoidable conjunction of what is internal and external to the project.

Investment, in this context, refers to projects that increase the stock of fixed capital/assets—that is, capital applied to new production or to expansion, modernization, or other forms of rehabilitation of production units, and not investments in marketable securities of existing enterprises, although the methods of investment appraisal are similar.⁵

The order of the chapters only loosely relates to a sequential design and appraisal process. In practice, the design can commence at any point and proceed through a wide variety of sequential and iterative stages. Chapters are independent, but inextricably linked. In the interest of maintaining continuity within each chapter, ideas that are important but peripheral to the main line of thought are added as appendixes and referenced in the text.

In addition to the main text chapters, two case studies are integral parts of the presentation. They are referenced at appropriate points in the text, covering supplementary topics: Cambria Yarns Project and Victoria Coke Project. These are available on our web site, www.wiley.com/go/investmentprojectdesign. The case studies underpin discussions and expositions on methods of design and analysis. The Cambria Yarns Project (CYP) is a new investment undertaken to exploit export opportunities for processed high-quality yarns rather than currently exported raw material. The case is analyzed for its commercial viability and also its impacts upon the national economy. Results of the financial analysis are integrated and labeled (e.g., Income Statement—CPY) at appropriate points in the text of Chapters 2–4, and results of economic analysis are included in Chapters 5 and 6.

The second case, the Victoria Coke Project (VCP), is an example of a rehabilitation project that results in restoration of capacity and operating efficiencies. It is undertaken as a joint venture between foreign and domestic partners. A predominant feature is the special methods of incremental financial analysis appropriate for this type of project. The issue of asset valuation and how it affects negotiations on share distribution is another aspect of the case. Results are completely contained on the web site. The project name is sometimes in the abbreviated form, VCP.

Chapter 1, Investment Environment, covers the framework for project design and development: the commercial and wider domains in which the enterprise is to be created and operated; design impacts of infrastructure and resource constraints; the rationale for strategic orientation, regardless of project size and complexity; and methods of developing strategies.

Chapter 2, Preparing Pro-Forma Financial Statements, deals with methods for generating income, cash flow, and balance projections as the basis for estimating performance indicators. In this chapter and the next, the main elements of analysis and results for the Cambria Yarns Project (see our web site) are interwoven into the text at appropriate points.

Chapter 3, Financial Indicators and Criteria, explains the derivation of performance indicators from financial statements and criteria for stakeholders related to opportunity cost of capital and to inflation, exchange rates, and risk; methods of analysis appropriate for projects of existing enterprises; and valuation of the enterprise in connection with joint venture and takeover negotiations.

Chapter 4, Financing the Project, reviews sources of equity, debt, and other capital to cover the cost of project assets and implementation, and both conventional and innovative financing schemes, including private-public partnerships.

Chapter 5, The Economic Perspective, regards the project's impacts on the regional, national, or international economy as a means of assuring compatibility with the host environment, including those directly related to operations and those that are external (i.e., social and economic effects that arise from the existence of the project but are unrelated to its commercial performance). Quantitative costs and benefits are identified and valued in terms of an economic accounting unit.

Chapter 6, Economic Cost/Benefit Analysis, is a guide for systematically compiling quantitative and qualitative effects of the project. A social discount rate is applied as a hurdle or challenge as part of the appraisal process; an alternative approach to economic assessment, value-added, is also discussed, and correspondences between the two methods identified. Analysis and results of the Cambria Yarns Project are included as appropriate in the text, including distribution impacts of savings/investment and direct consumption among social groups.

Chapter 7, Investment Decisions under Uncertainty and Risk, views the project design as a forecast, replete with uncertainties and associated risks in virtually every one of its design dimensions. Methods of identifying areas of uncertainty and assessing qualitative and quantitative risk are presented, as well as implications for stakeholders.

Chapter 8, Project Appraisal, discusses methods of arriving at an investment decision based upon a comparison of project performance characteristics that derive from design and analysis, the criteria of each type of participant—investor, financier, guarantor, regulator, licensor—and special concerns of foreign investors. Issues that may be of concern to each type of participant are identified, and discussion of appraisal reporting is included.

Chapter 9, Implementation Planning and Budgeting, explains the development of a preliminary implementation plan as prerequisite to decision making and detailed planning. Activation of enterprise functions in the preproduction phase (e.g., market development and procurement) constitute part of the implementation plan and costs. Project management and contractual alternatives are discussed.

Cambria Yarns Project describes the background and essential features of a project to convert domestically produced cotton into mainly exportable processed cotton yarn. Analyses of financial and economic viability of the project are integrated into the text at appropriate points. External agricultural impacts are internalized in the economic analysis (see our web site).

Victoria Coke Project describes an example of rehabilitation of a company suffering from deterioration of its production facilities, and from excessive use of production factors. Techniques of financial analysis for joint venture partners are covered (see our web site).

Note: All of the tables of the Cambria Yarns Project are included in the text, some in abbreviated form, which illustrate the structure of analysis. Complete Excel tables from which they were extracted can be found at our web site. Tables for the Victoria Coke Project are found only on the web site.

A comprehensive discussion of market issues is also included on our web site: Market Research and Marketing.

NOTES

1. William R. Easterly, The Elusive Quest for Growth: Adventures and Misadventures in the Tropics (Cambridge, MA: MIT Press, 2002). Easterly discusses why and how much capital investment in the developing countries has been wasted as a result of the failure of international investment promotion agencies to foster policies that would incentivize engagement in productive and profitable lines of market activity.

2. Biological organisms acquire their strategies through the process of evolution; natural selection molds both the organism and the manner of accommodating to its environment. However, strategic development among biological organisms is not very efficient. Essentially random mutations are tested against the prevailing environment and, if found wanting, are quickly obliterated. We see the vestiges only in fossilized remains of experimental organisms that took the wrong turn. Investors do not have the luxury of trial and error in strategic development for the enterprise, as the process would be unacceptably costly.

3. This begs the question: What is sustainable? In general, to be sustainable, employment of a resource does not diminish the possibility of consumption in the future. These are only a few possibilities: products designed for easy disassembly for recycling and reuse; products made from recycled and renewable materials; nonpolluting disposal (e.g., decomposition into environmentally harmless substances); energy conservation in buildings, manufacture, and product consumption; use of renewable energy sources—solar, wind, geothermal, tidal, hydro, biomass.

4. The term wider domain is used to indicate elements of the project's external environment beyond those traditionally considered as relevant to its design and analysis. This is explained in some depth in Chapter 1.

5. Investment that adds to the stock of productive assets is more assuredly a contributor to economic well-being than is investment in financial markets where the primary emphasis is on the price of assets rather than what they produce. Increments of productive assets (physical and intangible) increase national wealth and are conducive to improvement in the standard of living of the society as a whole.

Chapter 1

Investment Environment

The investment project creates an enterprise that functions in an environment comprising internal characteristics and external surroundings. Design of internal characteristics is essentially within the province of project personnel, but external features are variously susceptible to influence: Some are clearly independent of the existence of the project, others can be moderately affected, and some can be readily adjusted to serve project needs. Being aware of its features is the first step in assuring mutual compatibility between the investment environment and the project, which is essential to success.

A project is considered to be a set of coordinated activities intended to achieve a specific outcome, with a beginning and an end. The project starts when the investment idea attracts serious attention, progresses through preinvestment phases of study, design, analysis, and appraisal; then, if acceptable for investment, through commitment of resources and implementation, in which the enterprise is either created or modified, and production facilities assembled, constructed, installed, and then commissioned for operations. The decision to invest in the project is predicated on results of appraisal of the projected relationship between the investment and the excess of benefits over costs to be derived during the operations phase, as described in Chapters 2–4 (financial) and 5 and 6 (economic).

The enterprise commences operations as resources are consumed to produce goods and/or services (hereinafter referred to as products) provided to consumers; there follows a decommissioning phase, if applicable, or perhaps renewal in the next investment cycle. The project conception and design, and its appraisal, are inevitably predicated on forecasts that are inherently uncertain; thus, consideration of associated risks is an indispensable dimension of the planning process.

SYSTEMATIC PROJECT ANALYSIS

The investment project is most effectively studied and designed as a system, or perhaps a primary system with interacting subsystems. The enterprise in its environment is modeled as a whole rather than an assemblage of individual elements or parts. The description of system elements, structure, and processes, and their interactions, yields insights into their functions and dynamics, providing a basis for refining project design toward attainment of objectives and goals. This requires specifications of system elements and plans to effectively mobilize resources necessary for their proper functioning (e.g., energy, materials, labor, information, technology, finance) and creative conceptions about how they can be employed so that they are mutually reinforcing.

Design/study follows a logical, but not necessarily linear, sequence, often through several iterations, consisting of the following elements:

Goals and objectives—what is to be accomplished, and why, by individuals and organizations involved.

Criteria of acceptability for stakeholders—investors, lenders, guarantors, regulators, licensors.

Alternatives—the range of choices for design of the system and its components: product; enterprise organization and staffing; location; site selection and layout; plant and ancillary facilities; process; machinery and equipment.

Impacts of each alternative—resources consumed and generated and other tangible and intangible consequences.

Quantitative and qualitative forecasts of impacts to the planning horizon.

Benefits and costs to be counted—elements to be included in assessing profitability and other indicators of performance, and their individual, organizational and/or geographical range of relevance.

Unit of measurement for meaningful aggregation of impacts, and identifying impacts that can only be assessed qualitatively.

Determining quantitative performance indicators and nonquantifiable measures of project impact (e.g., commercial, economic, social).

Assessing risk—decisions predicated on uncertainty in forecasts and their possible negative impacts on performance.

Appraisal—comparing performance indicators and other impacts with criteria of stakeholders, considering risk of failure to meet criteria.

Recommending a course of action as the most favorable among alternatives.

For practical reasons, it is necessary to select only those aspects of the project with the most significant impacts for detailed analysis. Some impacts are best estimated in aggregated form using accepted rules of thumb. However, details can be important: What appear as minor factors at the outset can loom large when they become problematic.¹

A fundamental concept for all types of projects is incremental analysis, the difference between the situation for stakeholders with the project and without the project. This is not the same as after versus before the project. For a new investment the without-project situation is usually relatively straightforward. It is concerned with the current disposition, and effects for stakeholders, of resources that will be transferred or otherwise dedicated to the project. For a project undertaken by an existing enterprise, the without-project situation involves the operational scenario if the project is not undertaken. In either case, the incremental impact is the difference between the with-project and without-project situations. This concept is further explained in Victoria Coke Project case study, on our web site and in Chapter 3.

PROJECT ENVIRONMENT AND STRATEGY

An investment project becomes part of a system of supply and demand for goods and services, and also an integral part of socioeconomic and ecological systems within which it is to function and prosper. Its success depends upon how well it accommodates to its operating environment, as well as the degree of satisfaction that it provides to its clients and to the wider community that provides its market, its workers and those whose lives are affected by its presence. Whether the project is undertaken in an industrialized or developing country or a country in transition, the analogy of a biological organism employing a strategy to survive and grow in its habitat, or environment, described in the Introduction, is applicable.

In some environments, demonstration that the project will serve socio-economic goals and objectives and be compatible with the host ecology is required. Public interest is expressed through fiscal, administrative, environmental, and other conditions imposed by governing bodies requiring that the investment project employ scarce resources efficiently for local, regional, or national development. Government initiatives that encourage or compel adherence to public goals with incentives and restrictions enter into analysis and appraisal of the project.

The strategic plan might include factors involving corporate social responsibility (CSR) as a means of enhancing corporate image and reception of the project by the host community. For further discussion see our web site—Corporate Social Responsibility.

Project Domains

The relationship between the project's commercial domain and the wider domain with which it interacts is illustrated in Figure 1.1. The commercial domain comprises markets and suppliers, financiers, competitors, technologies, and internal project characteristics designed to produce desired benefits for investors. The wider domain is project-specific, encompassing the political, social, economic, and environmental milieu in which the enterprise is to function. It can be delimited geographically as the community (e.g., city), the region, the country, or the international setting, and operationally as the scope of major interactions between the project and external factors. In reality these domains are not so clearly demarcated—they are unified by interactions and mutual repercussions. As one example, aesthetics and culture (a feature of the wider domain) may affect the market—what people are willing to consume (a characteristic of the commercial domain).² A partial listing of elements of the commercial and wider domains for consideration is provided in Appendix 1.1.³

Figure 1.1 Commercial and Wider Domain

That project stakeholders are obliged to consider the commercial domain is obvious, certainly for private-sector projects and often in the public sector as well. Investors, guarantors, and lenders are interested in how a project will fare—securing market share and operating with sufficient financial returns. Why there should be interest in the wider domain is often ignored.

All dimensions of the wider domain have consequences—the economy, culture, nature of the political arena, consumption of natural resources (renewable and nonrenewable), the physical environment, flora and fauna, aesthetics, and the general quality of life of the affected population. Strains at the local, regional, national, and international levels are an important consideration for the project, needing markets with people willing and able to consume the output of the enterprise and to supply needed inputs. As the project is imposed on commercial and more extensive systems, its repercussions create ripples that are reflected back, sometimes in amplified form. In recent years the scientific community has discovered the phenomenon of chaos in complex systems such as weather or economies, in which small perturbations in one corner of the world can have major consequences in another—prototypically the butterfly flapping its wings in an African village causing a tsunami in Asia.

Although red flags of warning concerning resource constraints have been hoisted for centuries,⁴ human ingenuity has usually found a way to circumvent these problems. However, until the human population stabilizes (perhaps at 10 or 12 billion by the end of the twenty-first century, according to some forecasts), by definition a decreasing quantity of Earth's surface and natural resources is allotted to each on average, a factor that may warrant examination in regard to project viability.

There are other pragmatic reasons for maintaining an interest in the wider domain. International agreements have lowered barriers to trade and to mobility of production factors. For this reason alone, elements of the wider domain, within and without host country borders, affect project viability. Differences in environmental protection, labor conditions, and human rights provisions among countries, coupled with global mobility, have a significant bearing on the nature of existing and future competition.⁵ The project may benefit from heightened awareness by licensing authorities of external benefits attributable to the enterprise.

External effects, regarded as problematic by the larger community, also have to be identified and their long-term consequences for the enterprise taken into account. As information concerning consequences of resource consumption and applications becomes more widespread, the market will increasingly reflect impacts that presently do not affect the bottom line (profit) but that do have an impact upon interests of direct stakeholders and the broader community. To ignore these factors is to add to project risk. Better to account for these external impacts, derive the advantages of beneficial effects, and protect against unanticipated consequences of real or perceived undesirable impacts.

Industrial policy embodied in measures such as incentives, quotas, and protection may reflect the host government's strategic policies regarding the general business environment. Macroeconomic policies and actions may be relevant: for example, fiscal (liberal or conservative), monetary (tightening or relaxing), and foreign trade (export/import financing by the banking system, import quotas and other protective barriers, export/import duties, promotion facilities). Design of project and marketing strategy are affected by entry/exit barriers to participation, restrictions on foreign participation, policy on repatriation of earnings, and exchange controls. For example, the existence of exchange controls (usually responsible for local currency overvaluation) may render export difficult or impossible.

The wider domain has more direct significance. As an example, the state of flora and fauna may have implications for stability of needed inputs. A lake supplying cooling water to the project, if contaminated, can lose required qualities and consequently its usefulness for the project.⁶ Reliability and loyalty of workers are enhanced when health and quality of life are maintained at acceptable levels. Generally favorable economic conditions provide a healthy environment for the enterprise to survive and grow.

International and domestic terrorism is increasingly a factor with the potential to affect project outcomes, so that consideration of prevention and/or mitigation strategies is sometimes appropriate. For further discussion see our web site—Domestic and International Terrorism.

Size is a determinant of the degree of investigation: For relatively small projects, with little or no regional or national impact, assessing compatibility with concerns of the local community is probably as far as appraisal goes in the investment decision process. For an export project, the international economy and national parameters such as trade balance and exchange rates are relevant.

The extent of analysis has to serve the interests of stakeholders but also reflect the larger implications for sustainability of operations and public interest. A major issue is whether there is any conflict, at present and in the long run, between basic project (corporate) objectives and development objectives in the operational socioeconomic environment.⁷

At the micro (project) level, sponsors’ primary concerns for the project as a business opportunity, where commercial profitability is of paramount importance, invariably need to be supplemented with some concern for wider impacts, if only to satisfy licensors and regulators. When the project is either large enough or otherwise strategically significant, macro-level appraisal may be warranted, considering its contribution to regional, national, and perhaps international income, distribution effects, and job creation.

Examination of the wider domain can lead to alternative project configurations that benefit investors. For example, the cost of pollution abatement or mitigation can be weighed against adverse impacts if such measures are not taken. Enterprises have been held legally and financially accountable for contamination even when in compliance with emissions regulations.⁸ Projects planned for 10 to 20 years or longer can anticipate more stringent regulation and consider including anticipated compliance requirements in the initial investment cost.

Infrastructure Investment Projects

Infrastructure can most generally be considered as the entire range of elements of the wider domain, as previously described, or more commonly as service components of the project's external environment, provided by entities created with private investment, public-private partnerships (PPPs), or by the government. The complex of services is usually the cumulative effect of investments over an extended period of time—Rome was not built in a day.

Some infrastructure projects are designed as revenue generating, some completely supported by fees charged to users, and others with varying degrees of subsidization for consumers of services produced. Government subsidies can be provided for the investment and/or more directly to the consumer in the form of a price per unit of service lower than production cost. Other projects provide services without direct cost to consumers, such as roads and bridges that are free of user tolls.

Private investors regard infrastructure projects as any other investment, with acceptability based on criteria such as risk-adjusted cost of capital, payback, and breakeven. The public side of PPPs or strictly government projects, whether or not revenue generating, considers the economic consequences to a much greater degree. In fact, economic impact may be the primary criterion from the government's point of view.

For relatively small infrastructure projects (small to medium enterprise, or SME), such as technical services or local transportation, the approach to project design and analysis is similar to that for a manufacturing or service project. For large projects, such as hydroelectric, fuel-powered, or nuclear electricity generating stations, a very significant difference is financing (see the section on build-operate-transfer [BOT] financing in Chapter 4). Power plants may require investment in billions of U.S. dollars, so the financing arrangements are considerably more complicated than for SMEs.

The sheer size of these projects frequently requires government involvement. In smaller economies the investment is usually too great for the local private sector. Governments intent on economic development look upon the provision of infrastructure services as a means of attracting domestic and foreign investment. Under government sponsorship there is greater likelihood of subsidized prices (e.g., utility service rates) for industry as an inducement for investment.

Government sponsorship also reflects growth-oriented economic policy, particularly in developing countries. For the production of consumer and industrial goods, in principle governments have the option of direct investment (as in former centrally planned economies) or indirectly influencing investment by the private sector, the approach now followed by all but a few command economies. In this way, governments promote investment by creating a supportive environment, in which the barriers for entrepreneurs are lowered, and prospects for meeting criteria enhanced, with adequate and reasonably priced (or publicly supported) infrastructure.

Physical infrastructure (e.g., transportation, communications, energy) is the most important. Some projects produce commercial services, with any of the structures previously discussed. For self-supporting revenue projects, calculation of expected return is identical to that of industrial projects. If services are provided with some degree of subsidization or free of charge (i.e., nonrevenue), the design might be oriented to cost minimization and the economic perspective, which in effect weighs the cost of subsidies against the benefits provided to consumers and to the economy in general.

Need alone is not a sufficient criterion for selection of a project within existing constraints (financing is usually the most apparent). Less developed countries often also are confronted with an implementation constraint (alternatively, absorptive capacities constraint).⁹ Meaningful financial and economic analysis requires realistic assessments of benefits and costs under prevailing conditions. If the government is the sponsor, performance indicators for the project under consideration are compared with alternative uses of available capital to determine whether the project is a good use of public funds. Accurate estimation of benefits is the difficult part. Use of public funds imposes a need to analyze the effect on targeted beneficiaries, which is a function of numbers, income level, and social status. To avoid political bias, uniform standards for benefits and costs are applied across the country. In appraising alternative road projects, for example, cost savings accruing to users (per mile or kilometer) would be valued by the same or similar standards. For example, savings in fuel and maintenance would be the same for a project in one province or another, except for local adjustments (less developed regions might have slightly lower prices and wages).

The history of applying public funds for infrastructure projects across the world is not very encouraging. Large quantities of public funds have been expended on politically inspired projects of dubious utility, while socially valuable projects have often been set aside for lack of funding. Even in advanced economies, so-called pork-barrel projects are often added to completely unrelated legislative actions, sometimes in the dead of night to avoid public scrutiny. But that is another story.

Infrastructure as a Design Constraint

The enterprise to be created by the project exists in an environment in which it requires supportive services—infrastructure—to function and prosper. The surrounding community (local, regional, and national) has provided services whose costs are either shared or, in some instances, completely covered with public funds, a form of private/public synergy. The greater the proportion of required infrastructure provided by the community, the less the burden on the project to augment services to the point that they provide a healthy and adequately supportive environment. Interacting with public officials and community leaders is one way to smooth the way. In fact, in many communities, public works projects have been implemented for the sole purpose of attracting a desired industry.

Infrastructure is a public good that affects the capacity of industry in general, and the project in particular, to operate effectively. It often requires commitment of public funds, which is not always the first priority of budget authorities. Although there is ample evidence that infrastructure investment is a factor in the level of productivity, when the host economy is under stress the tendency is to divert funds to consumption rather than investment.

This is a problem even in industrialized countries. In the United States, on average since 1980, the growth of infrastructure investment has lagged behind overall economic growth. The result has been slow degradation of infrastructure, a worsening infrastructure deficit and mounting investment needs.¹⁰ In a 2006 study, Rodriguez¹¹ found that a measure of core infrastructure which included highways, mass transit, airports, electrical and gas facilities, water, and sewers had a highly significant effect on both labor and multifactor productivity: The decline in U.S. infrastructure investment after 1970 had led … to a decline in TFP (total factor productivity) growth of 0.8 percent a year—a very large effect.

Where infrastructure development requires commitment of public funds, government authorities tend to respond to what appear to be more pressing problems on their hands, to apply resources to the squeaky wheel, which becomes infrastructure only under dire circumstances such as the collapse of a bridge, a rail catastrophe, or a road washout from heavy rains or flooding.

The complex of infrastructure services, their availability, and the cost to the project is a key factor in location, best selected to optimize project performance. Services might be provided by private, private-public (PPP), or public entities. Private infrastructure investment is invariably for-profit, but its services are not necessarily more expensive than revenue-generating public services. Public services provided at no cost to the project (funded from taxation and other government sources) are usually the most desirable but subject to uncertainty if public coffers are stretched tight.

Project investment and operating costs would be much higher in some locations as compared with others in the country, the difference usually attributable to infrastructure—typically, access to no-cost or low-cost services. For this reason projects are rarely implemented in the desert (unless there are natural resources to exploit). In fact, a salient feature of location analysis is cost minimization, with the cost of transportation for inputs and outputs of primary importance. In light of the possibility of changes in the energy outlook, prudence suggests at least consideration of a futuristic view concerning transportation. Some analysts believe that the system of energy generation and consumption will undergo a virtual metamorphosis, with far less international, and even interregional, movement of goods and services.¹²

Infrastructure is a significant factor in site selection. Many projects of existing companies are essentially design replicas of plants already in existence. These can be considered black boxes that need connections to supporting supplies of nutrients—utilities and other services that derive from local infrastructure—with availability, cost minimization, and reliability the major criteria. They may also require connections to sites and other facilities for disposal of effluents and wastes. For an assembly plant, transport costs of components from upstream affiliates or suppliers are a major consideration in site (or location) selection.

Profitability is directly linked to the existence of infrastructure services. Without this kind of public support, project capital would be needed to create the facilities and services needed for profitable operation—roads, power supplies, water wells and treatment plants, housing facilities for workers if not otherwise available at the project site. It is no wonder that profitability of a project with the benefit of services provided with public support is more favorable than a similar project in a location where such facilities are unavailable. This explains, to some extent, why investments flow to favorable areas with well-developed infrastructure, unless high product value justifies expensive modes of transportation (e.g., gold and diamonds mined in Russian Siberia are transported by air, which would not be possible in the case of most of the other minerals waiting to be exploited there, were cheaper transportation available).

Cost structure is fundamental to a profit-oriented project but is important in any case, even for nonrevenue public service projects. Infrastructure services represent a significant part of the cost of operations in any case: The question is, what part of the bill, and how much, does the project have to pay? Projects to develop or expand the capacity of infrastructure are usually too large for an individual manufacturing project to handle. A power plant has to be large enough to exploit economies of scale—for example, 1,000 megawatts—while an individual energy user such as the project would rarely require more