NPV rule in gov’t

This is version 2 of a similar column I wrote a decade ago. It’s an issue worth reviving with the burgeoning capital expenditure projects the government is contemplating. It’s sometimes argued that the Net Present Value (NPV) criterion is appropriate for corporations but not for governments.First, government must consider the preferences of the community as a whole rather than those of a few wealthy investors. Second, governments must have longer horizon than individuals for governments are the guardians of future generations. What do you think?This question is typical in MBA discussions as it tests students’ understanding of capital investments techniques. But certainly, these considerations go beyond academic discussions. It delves deep into the roots of how government decisions are made.The basic unit of analysis in the capital budgeting process is the individual investment project. The basic objective of any major capital investment project is to increase shareholder wealth. The analysis would require assessing the cost and benefits of implementing the project and deriving an optimal strategy for implementation over time.Forecasting the likely cash outlays and inflows from the project is an important component of the process. Evaluating their likely effect on the market value of shareholders equity is the end goal.In private sector finance, the goal of maximizing shareholders wealth is captured in the net present value (NPV) rule. Simply stated, invest if the proposed project’s NPV is positive, i.e. the present value of future cash flows exceeds the initial investment after discounting these cash flows using the risk adjusted cost of capital.The objective of capital budgeting procedures is to assure that only projects that maximize shareholders value are undertaken.There’s also the problem of capital rationing. Sometimes, two or more projects are mutually exclusive, meaning the firm will only be able to take at most only one of them given limited resources.Investment purists also argue that a project is a good project regardless of financing source because a proper NPV analysis will not double count the financing cost as it should reflect in the risk adjusted cost of capital used to discount cash flows.Which lead us back to the question, should the NPV rule apply to government projects? Mark Griffiths of Thunderbird, The American Graduate School of International Management, has this retort to the NPV rule in government.“As long as capital markets do their job, all members of the community wealthy or poor, have the same rate of time preference, because they all adjust to the same borrowing-lending line. The government acts in all its citizens’ interests by choosing only investment having positive NPV at the market interest rate.”“The “longer horizon” argument, to the extent it is valid, requires a lower discount rate. It doesn’t require throwing away the NPV concept. But should the government ever use a lower discount rate? Note that the rate of return on incremental real investment in the private sector equals the market rate of interest. Why should the government divert the resources into public investments offering a lower rate of return? (That’s what the lowering the discount rate for public investment would allow). How would that help future generations?”“There are some cases where a lower discount rate might be justified, however. For example, NPV analysis might indicate that a wilderness mountain meadow be torn up for a copper mine, but We the people may decide to make it a national park instead. In part, this decision reflects the difficulty of capturing intangible benefits of the park in an NPV calculation.Even if the intangibles could be expressed as dollar values, there’s a case for discounting at a relatively low rate: People’s time preferences for wilderness recreation may not fully adjust to capital market rate of return.”Clearly, the issue of allocating government’s limited resources is a difficult one. But if one is to serve the stakeholders’ best interest, there has to be some concerted effort to use the technical tools of the trade in investment review.The question is whether such attempts are being made especially for laws and undertakings that will require major budgetary allocation.Take for example the cost of Republic Act 10931 or “Universal Access to Quality Tertiary Education Act”. In 2018 alone, Congress allocated P40 billion to fund the free tuition of state universities and colleges, and the funding will likely increase in the following years.What about the P55 billion estimate for the creation of the Federal government per estimate of Dr. Rosario Manasan of the Philippine Institute for Development Studies? And we are all familiar with the build, build, build infrastructure projects estimated at around P7 trillion to P9 trillion.These are all laudable undertakings but are the costs well studied and the returns appropriate to the risks and burden they impose on the community?We certainly hope the rigor of an investment review process is not neglected in the analysis and decision to undertake humungous public investment proposals.At the end of the day, we the people, the taxpayers, and the future generation will assume the burden of these decisions long after the crafters of these proposals have left their government posts.