Time has passed, the air has cleared, and the current problem is, you are presently involved in a decision about a capital improvement project which entails some cost/benefit analysis using net present value calculations, and you must make a recommendation to your new bosses, the County Commissioners at the next Commission meeting regarding two capital improvement alternatives, A or B as more particularly described in problem 6 of the Mikesell text on page 339.
An engineering firm, expert in cash flow analysis, was employed to advise the county regarding the economic viability of the two alternative capital improvements (A or B) that could be chosen. This consulting engineering firm has given its report to the Commissioners, but the Commissioners are vexed at the nettlesome calculations found in the study, and they have turned to you with a list of questions they would like you to answer for them at the next meeting.
The projects (A and B) described in problem 6 on page 339 require a four-part analysis, calculating the NPV and BCR for each option as follows:
1. Option A, using a discount rate of 10%
2. Option B, using a discount rate of 10%
3. Option A, using a discount rate of 5%
4. Option B, using a discount rate of 5%
The Commissioners have attached a copy of the first analysis, Option A, using a discount rate of 10% to the list of questions they prepared, and they want you to answer their questions using that part of the analysis only. The analysis is attached in the accompanying Excel worksheet (see next link after this one).
A summary of the results from the attached Excel worksheet is as follows:
Option A, NPV at 10% discount rate = $2,764,064 â€“ $3,418,433 = ($654,369)
Option A, BCR at 10% discount rate = $2,764,064/$3,418,433 = 0.81
Based on this portion of the report, the Commissioners ask the following questions:
1. Why do the engineers specify in the heading to the first column of each analysis â€œEnd of Yearâ€ rather than just year? Note that the Mikesell problem does not indicate if the payment occurs at the beginning of the year or the end of the year. The engineers seem to think this makes a difference. When doing cost/benefit analysis, why is it important to know if the payments occur at the beginning or the end of the year in question?
2. Note that the report indicates that the first row is n = 0 where n = 0 means the transaction occurs at the “present”, n = 1 indicates that the transaction occurred at the end of the first year and n = 2 indicates that the transaction occurred at the end of the second year. What would the future value equal in the formula, FV = PV(1+i)^n, where i = 10% and n = 0, if PV = 10,000?
3. It was determined to use a 10% discount rate for this problem. What might require that one use a different discount rate? That is, what does the discount rate represent? This is an important issue. Please answer in detail.
4. How did the analysts get the figure, 1,818,182 found in the column titled, â€œPresent Value of Annual Costs?â€ What was multiplied by what?
5. Explain the â€œDiscount Factor.â€ Why are the costs and benefits that occur in different years multiplied by a different discount factor for each year of occurrence? Differentiate between the “discount rate” and the “discount factor.”
6. This part of the study shows that the net present value of Option A with a 10% discount rate is ($654,369), a negative figure. How should this be interpreted? What does it all mean? If the county chooses to construct option A, will it have to write a check to the contractor for $654,369? Please explain.
7. The benefit cost ratio, BCR, for this project is .81. What does this mean? Does that mean the engineers are giving this alternative a grade of â€œB -â€? Can you make a general statement about the relationship between the NPV and the BCR for any project that is analyzed using these methods?
8. Mikesell discusses when it is appropriate to use the NPV method and the BCR method as decision rules for making a decision as to whether or not to undertake a project. What are the factors that would cause you to choose one method over the other? Can you tell which is better for the project described in problem 6? Why or why not?
9. Sometimes engineers (and public administration instructors) make mistakes in their calculations. The commissioners want you to check the calculations made by the engineers on this part of the project (Option A with a 10% discount rate). One particularly obnoxious Commissioner has pointed out that he can get some of the answers except for rounding errors.) Can you get the same answer as the engineers? Show your work for full credit. Is there an error in the calculation?
Written Assignment For the Discussion Forum: Fortunately, you have kept in contact with a group of classmates who took a public budgeting course several years ago when you were working on your master’s degree. Actually, the group made a sacred pact that if one of the group members were ever faced with a mathematical dilemma involving net present value calculations or benefit cost ratios, you would come together as a supportive group and assist one another.
Written Assignment For the Dropbox: Answer each of the nine questions for the commissioners and post your answer to the dropbox for this assignment.