The diminishing marginal effectiveness of the discount rate as a screening device

Abstract

Large public investments, such as major industrial plants, power stations or investments in human capital or environment are sensitive to the discount rate due to their long planning scale. When such projects are endowed with special earmarked foreign loans, which would otherwise not be available to the country, the effectiveness of the discount rate as a screening device is greatly diminished. Even in projects that display a ‘normal’ investment-benefit time profile, a ‘non-conventional’? NPV function can occur if such projects are financed by a ‘tied’ loan. The NPV shape is examined under different project parameters and loan conditions, and three definite regions are defined in which the NPV patterns differ significantly from the classical shape. The results are illustrated with data from a power plant in Israel.

Keywords:

• discount rate
• public investment
• foreign loan