Reference no: EM131374640

MINI-CASE
Associated Engineering conducted an evaluation of sources of water supply for a municipality. One of the considerations was the choice of high-pressure or conventional pipelines for transmitting treated water to the municipality from a distant water source. Conventional pipelines, most often made of concrete, have a limited maximum tensile strength, which for analysis purposes was taken to be 200 pounds per square inch (psi). High-pressure pipe, made of steel, can withstand up to 60 000 psi, although the pipe examined by Associated Engineering had a strength of 42 000 psi.

The major advantage of the steel pipe is that fewer pumping stations are needed than with the concrete pipe. The distance to be pumped is 85 kilometres; this requires either one pumping station for high-pressure pipe or six pumping stations for concrete pipe. Each pipeline type was analyzed over a range of pipeline diameters ranging from 24" to 72". Construction costs included the pipe, pumping stations, and a reception reservoir, with the time of the cost taken to be the commissioning date of 2025. Operating and maintenance costs starting in 2026 were included, and administration, engineering fees, contingencies, and taxes were also accounted for. The best alternative was chosen on the basis of a present worth comparison with a 4% discount rate. In the analysis, real 1993 dollars were used and an inflation rate of 2% was assumed for the period of study. The result was that a 360-diameter high-pressure pipeline was economically best, at a present cost S7.5 million lower than for the best conventional pipeline.

Discussion
Estimating future inflation is difficult. The average inflation in manv developed countries over the last 50 years has been about 4%, but there have been periods of several vears when it has been 2% to 2.5%. For some other periods, inflation has averaged over 10%. Historically, many countries have experienced hyperinflation (extreme inflation) or even deflation. How can we estimate future inflation? One way is simply to assume that inflation will remain at the current value. This is probably wrong; as has been seen, inflation typically changes over time.

However, there are factors that are controlling the inflation rate. Lacking knowledge of any reason why these controlling factors might change, the current rate seems to be a reasonable choice. A second approach is to use the long-term average. Knowing that inflation will change over time suggests that the long-term average is a good choice even if inflation is lower or higher than the average right now. After all, those controlling factors have changed in the past and are likely to change again.

A third way is to take into account the controlling factors for inflation. These include government policy: a government committed to social welfare is likelv to induce more inflation than one committed to fiscal responsibility. Trends in business and consumer behaviour affect inflation: large labour contract increases presage inflation, as does high consumer borrowing. Social trends like the aging of the baby boomers also have an effect on inflation. Understanding the effect of the controlling factors for inflation in detail is very difficult. So usually decision makers make a broad judgment based on both the current inflation rate and the historical average, and perhaps informed by a general understanding of the contributing factors.

Questions:
1. How significant would the difference have been to the savings of the high-pressure pipeline if an inflation rate of 4% had been used instead? -Assume the only difference between the concrete- and steel-pipe systems was the capital cost, expended in 2025. Would the decision be any different? Could it be different for any assumed inflation rate?

2. Design two cash flow structures for projects that start in 2025, such that the present worth in the current year at a discount rate of 4% is higher for one project than the other at an inflation rate of 2%, but lower at an inflation rate of 4%. Is there a significant opportunity to control the best choice in a decision situation by selecting the appropriate inflation rate?

3. Why would the analysts have chosen to separate the inflation rate from the discount rate for this problem, rather than combining them into an actual dollar discount rate? Do you think the analysts estimated the actual dollar cost of the alternatives in 2025, or would thev have used the real costs?