Question
The state of Glottamora has $200 million remaining in its budget for the current year. One alternative is to give Glottamorans a one-time tax rebate.
The state of Glottamora has $200 million remaining in its budget for the current year. One alternative is to give Glottamorans a one-time tax rebate. Alternatively, two proposals have been made for state expenditures of these funds. The first proposed project is to invest in a new power plant, costing $200 million and having an expected useful life of 20 years. Projected benefits of the new power plant are as follows:
Years | Benefits per Year |
---|---|
($ Millions) | |
1 - 5 | 0 |
6 - 20 | 40 |
The second alternative is to undertake a job retraining program, also costing $100 million and generating the following benefits:
Years | Benefits per Year |
---|---|
($ Millions) | |
1 - 5 | 40 |
6 - 10 | 28 |
11 - 20 | 8 |
The state Power Department argues that a 5 percent discount factor should be used in evaluating the projects because that is the governments borrowing rate. The Human Resources Department suggests using a 12 percent rate because that more nearly equals societys true opportunity rate. The present value interest factor at the end of years from 0 - 20 for the two discount rates are given in the following table.
Discount Rates | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | 14 | 15 | 16 | 17 | 18 | 19 | 20 |
---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
5% | 1.000 | 0.952 | 0.907 | 0.864 | 0.823 | 0.784 | 0.746 | 0.711 | 0.677 | 0.645 | 0.614 | 0.585 | 0.557 | 0.530 | 0.505 | 0.481 | 0.458 | 0.436 | 0.416 | 0.396 | 0.377 |
12% | 1.000 | 0.893 | 0.797 | 0.712 | 0.636 | 0.567 | 0.507 | 0.452 | 0.404 | 0.361 | 0.322 | 0.287 | 0.257 | 0.229 | 0.205 | 0.183 | 0.163 | 0.146 | 0.130 | 0.116 | 0.104 |
Evaluate the projects using both the 5 percent and the 12 percent rates.
Project | Net Benefits at Discount Rate = 5% | Net Benefits at Discount Rate = 12% |
---|---|---|
($ Millions) | ($ Millions) | |
Power Plant | ||
Job Retraining Program |
If you agree with the Human Resources Department that the social opportunity rate is the appropriate discount rate, which project will you choose?
a. Job retraining program
b. Power plant
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