Question

Question Three

Explain why the discount rate for the time preference method is different than the discount rate for the social opportunity cost of capital. For a public project with a very long time period (say 40 years) and very high initial capital costs, show how the discount rate can have a major impact on the social NPV. (give a numerical example of each method)

Answer 1

Time preference method: Time preferences are generally calculated mathematically in the discount function. The higher the time preference, the greater the discounts placed on returns receivable or costs that are payable in the future.

Social rate of time preference: It is a measure of society's willingness to postpone private consumption to consume at a later period. An indicator of social rate of time preference is the earning rate on personal savings by individuals. Social opportunity cost of capital is a measure of the marginal earning rate for private business investments. The key concept here is what rate attracts the business capital.

FOr a public project with a very long time period of about 40 years and high capital costs, the discount rate will have a major impact on the social NPV. For example, discount rate of 14% at an initial capital cost of 100 crores for 40 years will have much cost of capital than capital costs at 10% discount rate.