Question

Three public investments are considered: a new highway, a new health center, and a new park.

a, What might be the difficulties in having to select among these alternatives?

b. Use a graph to show the functional relationships between NPV and the discount factor (r)

c. What assumption is made when using the same r for the analysis of these investments?

d. How could a budget constraint affect the ranking of these investments? Be brief and specific.

Answer 1

a) It is difficult to assess the social impact of these 3 ventures and without that, making a decision will not be wise

For example creating a hospital might end up saving a lot of lifes, and that impact will not be able to decode in a financial analysis

b)

NPV is inversely proportional to the discount factor. As the discount factor reduces the future cash flows, we will have a lower NPV

c)

The assumption is that the risk return profile for all these investments are the same, which will warrant for an equal r. That is actually factually wrong and hence cannot be taken

d)

A budget constraint could inhibit these investments as without sufficient funds, you will not be able to construct the project and you cannot produce sub-standard output as these all are public utilities and warrant the highest quality to serve the people of the state