From theory to application: Using the economic internal rate of return (eirr) for assessing the profitability efficiency of the rural infrastructure investments in Huong Khe district, Ha Tinh province

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This paper presents the findings of an analysis of rural infrastructure investment program in Huong Khe district, Ha Tinh province. Through the conversion factors from the Central Bank of Vietnam, the monetization process was conducted for both types of rural roads & bridges and irrigation systems.

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Nội dung Text: From theory to application: Using the economic internal rate of return (eirr) for assessing the profitability efficiency of the rural infrastructure investments in Huong Khe district, Ha Tinh province

JOURNAL OF SCIENCE, Hue University, Vol. 70, No 1 (2012) pp. 255-263 FROM THEORY TO APPLICATION: USING THE ECONOMIC INTERNAL RATE OF RETURN (EIRR) FOR ASSESSING THE PROFITABILITY EFFICIENCY OF THE RURAL INFRASTRUCTURE INVESTMENTS IN HUONG KHE DISTRICT, HA TINH PROVINCE Nguyen Van Toan1, Thai Thanh Ha2, Nguyen Ngoc Chau3 1 2 Hue University National Academy of Public Administration 3 College of Economics, Hue University Abstract. This paper presents the findings of an analysis of rural infrastructure investment program in Huong Khe district, Ha Tinh province. Through the conversion factors from the Central Bank of Vietnam, the monetization process was conducted for both types of rural roads & bridges and irrigation systems. Then, several key assumptions were made to arrive at the economic profitability efficiency level, with the values being 96% for roads and bridges and 12.43% for irrigation canals respectively, using the theoretical concept of the Economic Internal Rate of Return (EIRR). On the basis of the findings, discussions were made and lessons to be learnt for both academicians and practitioners were drawn from this paper. The paper also implies that the following factors are crucial for the success of rural development program. They are related to (1) selection of the right rural infrastructure investment to maximize the economic benefits; (2) participatory community monitoring; and (3) the support from local authorities for Operation and Maintenance. Keywords: Economic Internal Rate of Return; Rural infrastructure; Huong Khe district; Ha Tinh province. 1. Introduction and rationale for using EIRR in assessing rural infrastructure investment The Economic Internal Rate of Return is a rate quantity, an indicator of the efficiency, quality, or yield of the investments. This is in contrast with the net present value (NPV), which is an indicator of the value or magnitude of an investment [1]. The EIRR analysis was introduced to relieve some concerns over the sustainability of construction works, especially in the long-term financial context. The practice of calculating EIRR is deeply established in a theoretical term. However, it has yet to be so often applied in a rural investment-specific situation such as a poor rural district like Huong Khe of Ha Tinh province. This paper is, therefore, limited to applying the concept of Economic Internal Rates of Return (EIRR) in a practical context of the rural 255 256 From Theory to Application: Using the Economic Internal Rate of Return… infrastructure investment in Huong Khe district, Ha Tinh province [8]. The objective is to provide the practitioners and policy makers with an economic benefit overview for rural development program on roads, bridges and irrigation canals made at the value of more than VND 8.0 billion in a long-term investment horizon. And the auxiliary product of this paper is to contribute to the theory of financial management via the analysis of the specific rural development program. 2. Methodology and data sources used in Huong Khe district, Ha Tinh province The Economic Internal Rate of Return (EIRR) on the investment is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV) of all cash in-flows and cash out-flows from this particular investment equal to zero [1]. In mathematical terms, the EIRR is expressed in the following equation: Where: CF0 is equivalent to the capital cost or initial investment for each rural infrastructure NCFi is the Net Cash Flow for the ith year along the investment horizon of 40 years EIRR is the Economic Internal Rate of Return which makes the NPV equal to zero. The most challenging issue in the EIRR analysis is related to the estimation of the yearly Net Economic Cash Flows [2]. And they should be made under a series of assumptions that are to be discussed in the next paragraph of this paper. The data that have been used for the EIRR calculation were taken from the following sources: - Financial data from Huong Khe district’s department of Economics and Investment Planning concerning the rural infrastructure projects (i.e. capital costs and timing of budget disbursement and so on). - World Bank Commodity price data (pink sheet) [7]. - Vietnam and Ha Tinh Statistical Yearbooks 2008 to 2011[8]. - Field discussion with key beneficiaries related to respective types of investment and districts with regards to rural bridges and roads and irrigation canals were made during the field observation. Due to limited time and costs, it was advisable to take the use of convenient sampling method and in-depth interview to have basic information for EIRR assessment. NGUYEN VAN TOAN, THAI THANH HA, NGUYEN NGOC CHAU 257 - The discussion with rural infrastructure construction companies on various issues in relation to the construction works such as the timing; technical specifications; and the perceptions of the contractor with regards to the economic benefits in the long run as well as the post-construction issues well into the investment horizon. - Cost / revenue information and estimations disclosed by beneficiaries (i.e. transport on road; time saving due to better road; facilitation of agricultural product exchange; and double rice season, etc.). - Based on the conversion factors by the Central Bank of Vietnam, the remuneration per person per year and other monetary issues were assumed and projected in a numerical way. 3. Key Assumptions of the EIRR analysis in Huong Khe district For simplicity calculation, the EIRR assessment for Huong Khe district, Ha Tinh province was made under the following key assumptions: - Even each individual construction work was completed at different points of time it was assumed that all of them will have a simultaneous impact on Huong Khe district’s economy at the start of 2012 at which the current price value is to be adopted for estimating the yearly streams of economic benefits and costs. - Inflation rate and Consumer Price Index (CPI) were ignored in the EIRR calculation due to its complex and unforeseeable projection in a long-term investment horizon. - Other possible indirect or spill-over effects related to the investment, were also discounted from the EIRR assessment. - ADB and WB usually indicate an acceptable benchmark of 12% EIRR which should be used in the profitability assessment for all of the construction works in Ha Tinh. - Although the majority of construction works are designed as forever-lasting infrastructures for civil service purpose, in reality their life cycles are limited. Namely, the bridges, roads and irrigation canals all have life cycle of 40 years which should be used to calculate the EIRR for the rural infrastructure investments in Huong Khe district. - Operations and Maintenance (O&M) costs: allocated as 10% of district O&M budget of 0.8 billion per year plus 20 million VND contributed by each commune for every constructions works in assessment. - In principle, each infrastructure investment will generate its own EIRR. However, on a broader scale, the overall EIRR for the whole Huong Khe district should take the amount of the initial investment capital into consideration. Therefore, weighted EIRR was suitable to adopt in the calculation. 258 From Theory to Application: Using the Economic Internal Rate of Return… 4. Monetization and conversion factors of economic benefits and costs for rural infrastructure investments in Huong Khe district, Ha Tinh province The yearly net cash flow streams were estimated via the monetization process with the usage of the conversion factors for economic benefits and costs [4]. It must be mentioned that the numeric data could not be projected with 100% accuracy due to the seasonal variations brought about by many factors. For this EIRR assessment the benefit evaluation methodology used a predominantly cost savings approach as a proxy for both non-incremental and incremental output [6]. For the sake of simplicity therefore, this paper does not distinguish between non-incremental and incremental benefits in the quantitative analysis. In light of this principle the cost streams were also adjusted by shadow pricing domestic and labor, materials, and other inputs. Both benefits and costs are expressed in the same numeraire; the conversion factors are drawn from the Central Bank of Vietnam. The following paragraph describes the monetization process for each type of rural infrastructure investments: Roads and bridges - Cost savings due to improved road: Cost savings per person-day is a conservative level of 100,000 VND along with the weighted degree of infrastructure investment of the same type. - Increase in price of land lots adjacent to the new roads and bridges: calculated by multiplying the total kilometers with increase in land price and weights for investment per district. - Time savings due to efficient traffic thanks to better public services: 10% of beneficiaries with a remuneration of 3.6 million VND per year. - Incremental revenue due to better transportation of products to markets: 50% of beneficiaries will have a chance to increase revenue due to better transportation with 8,000 VND per month. - New employments in transportation sector: estimated number of 100 persons employed in transportation sector due to the new system of roads and bridges. - Operations and Maintenance (O&M) costs: 10% of district O&M budget of 0.8 billion VND per year plus 20 million VND contributed by communes. - Loss of land due to new roads: calculated by weights in total investment multiplied by a total length of 92.439 km with 20,000 VND land rental as opportunity loss. Irrigation canals - Increase in land price: 3% increase in land price with a level of 1 million VND per hectare NGUYEN VAN TOAN, THAI THANH HA, NGUYEN NGOC CHAU 259 - Incremental revenue for second rice season and incremental revenue from higher rice productivity: Calculated with the average rice productivity in Ha Tinh from 2008-2011 according to Ha Tinh Statistical Year Book, along with crop rice budget. - Incremental revenue due to fish and other foods: calculated at 500,000 VND in fish revenue or other naturally cultured animal per hectare. - Savings from pumping stations: calculated with pumping cost per hectare 100,000 VND when there is no irrigation system. - Operations and Maintenance (O&M) costs: 10% of district O&M budget of 0.8 billion VND per year plus 20 million VND contributed by communes. - Opportunity costs for the loss of land assigned to build irrigation system: estimated with a level of 0.01% of land area loss due to irrigation, multiplied along with the Net revenue per hectare. The infrastructure investments for both types are estimated to be at 40 years old. This life cycle is to be used in calculating the EIRR. The analysis tool used in the calculation of yearly net cash flows and EIRR is the built-in IRR function available in Excel software. 5. Findings The district of Huong Khe, Ha Tinh province had a more than acceptable level of 12% EIRR as set out by the World Bank and the ADB for both rural roads and bridges; and irrigation canals [3; 7]. The most financially viable type of rural infrastructure is completely related to the irrigation works which play a vital role in revitalizing the rice productivity to a higher level or turning the one-season of rice into the double one. This can be seen as a success of rural infrastructure program in the sense that poverty or livelihood hardship is still faced by the rural poor people who are heavily dependent on the agricultural production or rain-fed rice cultivation. Making the rice land field work better for the poor can be considered as a financially sustainable option in the long run [4; 5]. The results for irrigation canals and rural roads & bridges are presented in Table 1 and Table 2 respectively. It was revealed that the EIRR for irrigation canals reached the level of 12.43% while the roads and bridges generated the EIRR of 96%. Even when both type of rural infrastructure investments have surpassed the ADB and World Bank benchmark of 12%, it is worth mentioning that the irrigation canals are above the hurdle bar with a narrow margin of 0.43%, giving rise to the doubts over financial viability in the long run. In contrast, the road & bridge investments have far more exceeded the ADB or World Bank rate of 12% [2], reaching the sky-rocketing rate of 96% which is as much as 8 times as compared to the ADB and World Bank benchmark.