Public Investment Criteria: Economic Internal Rate of Return and Equalizing Discount Rate

Abstract

The economic analysis of a project is aimed at determining whether the project is consistent with the overall national and sectpral objectives and whether the investment proposed represents the best means of achieving the intended objectives. The process of economic analysis can be seen as a sequence of actions. First, it is necessary to identify the need or demand for the project. The second step is to establish whether the proposed project provides the least cost or the most cost-effective way of attaining the objectives of the project. Having identified the project's costs and benefits and carefully quantified them, the third step is to ascertain whether the net benefits expected from the resources allocated to the project would be in excess of, or at least equal to, the net benefits to the economy that could be expected if these resources were made available for the best alternative project. These three steps are distinct but interrelated. The literature on public investment criteria has focussed attention on the third step whereby the net discounted present value and economic internal rate of return (EIRR) have emerged as the main criteria for judging the economic viability of a project. The purpose of this paper is to focus attention on the second step in which· the least-cost solution is determined. Apart from highlighting the is!sues involved in deriving the least-cost solution, some insights about the linkages of the three steps in the process of economic analysis of projects will emerge. The standard literature on the theory of the firm will be used to provide the analytical backbone of this paper. Starting frc>m a simple static one-period model, we will move to a static multi-pe,riod framework which will provide the basis for the discussion of investment criteria that is to follow. In sections II and III the emphasis has been to clearly distinguish profit maximization from least-,cost solutions, thereby providing the rationale for the distinction between EIRR and the equalizing discount rate (EDR). While the model described in section III is rarely used in determining the least-cost solution among project alternatives, its usefulness lies in allowing a rigorous examination of the issues involved. It provides the linkage between the three steps described above in the economic analysis of projects. A numerical example is given in order to clarify the issues involved.