A government project with the objective of advancing the technological capabilit

Question

A government project with the objective of advancing the technological capabilities of the nuclear industry will cost $100 Million. It is believed that 80% of those funds would have come from investment and 20% from consumption. The before tax rate is 8% and the after tax rate is 5%.

a) What is the discount rate for this project?

b) Some economists would argue that using private rates as reference is wrong in this particular case. Why might they be right? Should the correct rate be higher or lower than in (a)? Why?

Explanation / Answer

a)Cost = $100 Million
So, Investment = 0.8 * 100 = $ 80 million and consumption = $20million
Pre-tax rate = Post-tax rate/(1-tax rate)
=> 1- tax rate = 0.05/0.08
=> tax rate = 0.375 = 37.5 percent
Discount Rate = 37.5 percent
b) Because the discount rate is very high as compared to pre and post tax rates.
The correct rate will be lower than in (a).

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