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Selection of Interest and Inflation Rates for Infrastructure Investment Analyses [SD2012-05]
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2013-11-30
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[PDF-1.32 MB]
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Edition:Final Report August 2012 – November 2013
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Abstract:Engineering economic analyses (EEA) apply economic methodologies to engineering problems for decision-making support, such as life-cycle cost analysis (LCCA), benefit-cost analysis (BCA), incremental benefit-cost analysis (IBCA), and present worth analysis (PWA). When conducting an EEA, interest and inflation rates are the two critical factors. Using inappropriate values for interest and inflation rates could affect decision-making, such as unfairly favoring specific industries (e.g. concrete over asphalt or vice versa), over- or under-budgeting future projects. Therefore, it is necessary to identify the appropriate methodology to measure interest and inflation rates to enhance the credibility and reliability of investment decisions. The current assumption of a zero interest rate in the SDDOT EEAs may be problematic. Zero interest rate is unable to differentiate projects with various life cycles but in reality, interest rates vary by time. Additionally, the use of a general inflation rate at SDDOT may also be debatable. It is known that the price of materials and labor can vary by type and area. Hence, choosing and establishing sound interest and inflation rates is important for SDDOT to defend its investment decisions. In this study, SDDOT’s current uses of interest and inflation rates were identified through interviews. The new approach to establishing interest and inflation rates was developed from the combination of basic economic principles and state-of-the-art methodologies. Specifically, a non-zero interest rate was calculated by the treasury and state-issued bond yields; the region- and material-specific inflation rates were measured, calculated, and applied to the SDDOT LCCA studies; and the composition of SDCCI was re-examined and modified. Since the construction materials and items evolve over time, incorporating new and significant bidding items (e.g. traffic controls) to SDCCI ensures a proper measure and track of price changes associated with highway projects. In conclusion, this study introduced improved methodologies to calculate the discount rate for an EEA, presented the advantages of using a more specific inflation rate over a general inflation rate, and illustrated the consequence of selecting inappropriate rates.
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