2. The government of Legoland is thinking of building a (Lego) bridge to Furbyvi

Question

2. The government of Legoland is thinking of building a (Lego) bridge to Furbyville.

a)Suppose that the bridge costs $2,000 to build in year zero, and they expect to get $3,000 in year one (due to increased trading with the Furbys). What is the internal rate of return? If the interest rate is 3% is this project admissible? Justify your answer.

b)The government of Legoland can instead use a boat to ferry goods to Furbyville. They now must decide which project to undertake. The interest rate is 3% and the stream of net returns (benefits - costs) for each project is as follows:

Year

Bridge

Boat

0

-2000

-1000

1

3000

2500

2

5000

3000

Which project do they undertake? Explain your answer.

c)Legoland also has the ability to hire a private company to complete the project (build the bridge or boat). Should the government provide the bridge or should they hire a private company? Give two justifications for your answer.

Year

Bridge

Boat

0

-2000

-1000

1

3000

2500

2

5000

3000

Explanation / Answer

Ans a – The internal rate of return is the rate of interest where the net present value of the project is zero. The internal rate of return in this scenario is 50%. The project should be admissible at 3% as the project has a positive NPV.

Ans b – They must undertake the project which has the higher NPV. They should build a bridge.

Ans c – The government should build the bridge themselves as there would be no hidden cost involved by any third party.

Secondly, the completion time and the management of the project will be in the hands of government.

Year Cashflow Interest Present value NPV 0 -2000 3% -2000.00 912.62 1 3000 3% 2912.62 Year Cashflow Interest Present value NPV 0 -2000 50% -2000.00 0.00 1 3000 50% 2000.00

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