Minimum Attractive Rate of Return for Public Investment
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A discussion of methods of determining a minimum attractive rate of return for public investments. In order to clarify the fundamental logic of interest, the first part of this paper considers a riskless world in which there would be no uncertainty and, hence, no distinction between equity and debt securities. In this environment, the present-worth rule for making investment decisions will always work, but the prospective-rate-of-return rule is not consistently correct. In the real world, there is a risk distinction between equity and debt financing. In general, the weighted average of the stock and bond yields in the existing capitalization should be used as the discount rate for investments that leave the firm in the same risk-class as before. In the public investment area, the riskless rate can be used, except for variability risk situations comparable to private utility projects, where a compromise rate might be indicated. Where bias, or over-optimism, exists, additional percentage points should be added to the rate.
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