Question

Consider a proposed project in which an initial investment of $10 million would produce an annual financial benefit of $3 million. The project is intended to improve water quality and increase the efficiency of the water delivery system in the region.The financial benefits relate to two factors:

. There would be less leakage in the pipes used to transport water to the city from the reservoir.
. The proposed treatment program would be more efficient.

The life of the project is expected to be 100 years. Two-thirds of investment is related to replacing the pipes to eliminate the leakage, while the rest is related to upgrading the treatment facility. The project would be financed either by selling bonds or borrowing money from a local bank; either way, the annual interest rate would be about 4–5%. A hearing has been scheduled for the project, and several speakers have been asked to present their viewpoints. What is the main point that you expect each of the following people to make at the hearing?
a. A banker whose bank has made many loans to the city to finance a variety of projects. (The banker is known to prefer projects whose financial benefits are sufficient to cover the financial costs of the investment.)
b. An environmental advocate who recently wrote an article entitled ‘‘Discounting Is Unethical—We Must Not Overlook Benefits to Future Generations.’’
c. A doctor who believes that the new water treatment system will lead to a measurable improvement in health for the region.
d. A farmer whose crops depend upon a reliable supply of water
e. A politician who is in the midst of an election campaign; his slogan is ‘‘It’s high time for low taxes.’’
f. His opponent, whose slogan is ‘‘Build now for our children and for their children.’’
g. A civil engineer at the local university who recently completed a study of the water supply system. (Among the results of the study was a finding that two major leaks caused 80% of the loss of water; these leaks could be fixed for less than $5 million, and the rest of the system should continue in reasonable condition for another 20–30 years.)

h. The chair of a citizen’s advisory committee that advises the mayor on all major infrastructure projects that involve use of taxes to cover operations or investment. (This group used the federally recommended discount rate of 7% to determine that the benefits of $3 million per year over the life of the project would have a present value of more than $40 million.)

i. Finally, since you are related to the mayor and you are known to be an excellent student with an interest in infrastructure, you have been asked to listen to all of the previous speakers and summarize what you feel should be done.

Answer 1

(a)the banker would calculate whether the financial benefit of $3 m will cover the annual instalment of loan of $10 m at 4 to 5% rate of interest.Assume that the banker has to give a loan of $10m OR $10000000 at 5% for 10 years.So the annual instalment can be calculated as follows

• present value = annual instalment x present value annuity factor at 5% for 10 years
• 10000000= annual instalment x 7.722
• So annual instalment = $1295001 which can be easily paid out of $3m or $3000000 received annually. So the banker will have no problem with the project
• (b) environmental advocate is not interested in the cost benefit analysis of the project. He would be concerned whether upgrading the water treatment facility would vause any environmental pollution problems
• (c) Doctor would go for the project since it will improve the health of the people in the region
• (d)since the project improves water quality and also increases efficiency of water delivery system , he would get a good supply of water for his crops. So he would be like to go for the project
• (e) since the project is not financed out of public funds, there would be no incidence of taxes on the public.So the politician should not have any problem with the project
• (f)His opponent's view would be go for a project that gives benefits for a very long term.Since the project has a 100 year life, he would agree for investment in the project
• (g) $10m x 2/3= $6.66m is the investment for eliminating the leakage, whereas the civil engineer feels this could be fixed for less than $5m.So he would not find this project very cost effective.
• (h) The citizen's advisory committee has calculated the present value of investment as more than $40m will approve of the project, since the present value of benefits , which is say, $40m is more than the initial cost of $10m, which gives a positive NPV
• (i)SUMMARY
• for calculating the present value of benefi\ts, we can consider a discount rate of 5% , since the project will be financed with borrowing at 5.%.
• present value of cash inflows willo be $3m x present value interest factor of an annuity at 5% for 100 years
• = $3m x 19.8479= $59.54m .initial investment = $10m
• So NPV= present value of cash inflows- initial investment= 59.54-10= $49.54m which is positive. So the project is recommended