Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 1 of 18 Asphalt compared to Concrete for Highways An Exploration of Discounted Cash Flow Analysis in Practice

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 2 of 18 Basic Practical Issue: Which Technology? l Technologies often differ in Pattern of Cash Flows l A typical situation: –One may cost more, but save money, last longer –Another may be cheaper immediately, but cost more to operate, fail earlier l Let’s look at a practical example

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 3 of 18 Choice of Highway Pavement: Asphalt or Concrete l Concrete lasts longer -- is more expensive l Asphalt less expensive to place, but fails earlier l Both pavements eventually have to be resurfaced - typically with an asphalt coat l Which technology is better?

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 4 of 18 What is Life of Technology? l What is the “life” of equipment? l At what point does it fail or “die”? l Consider ‘statistical’ Analysis of US Experience, s –Life of Asphalt ~ 17 years –Life of Concrete ~ 27 years l Can we believe this?

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 5 of 18 Examination of Data on Highway Life l 1920s -- Boom Period - –Concrete highways l 1930s -- Depression –Asphalt highways l 1940s -- War –“Nothing” built l 1950s -- Reconstruction –Average age of concrete: 27 = –Average age of asphalt: 17 =

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 6 of 18 How might we determine life of project? l Set up Objective Criteria? –Such as?…… l Technologies fail differently… Test for failure of one does not apply to other... –Asphalt deforms, ruts –Concrete cracks l Ultimately, this is very subjective...

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 7 of 18 Example Analysis l Assumed Numbers –Asphalt costs 1000/unit initially –Concrete costs 20% more, 1200/unit –Cost of Resurfacing is 400/unit for each l See Example

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 8 of 18 Excel Set up for Analysis

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 9 of 18 PV of Asphalt (left) vs. Concrete (right) Breakpoint ~ 3.5% (in this example)

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 10 of 18 Cost Advantage of Concrete (Chart)

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 11 of 18 Lesson from Comparison l Choice of Technology may depend on choice of discount rate l Those who determine Choice of Discount Rate may be true designers l Why was most of US Interstate Highway System originally built of concrete? l but privately financed toll roads (such as Mass Pike) were not?

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 12 of 18 Finance Policies Influence Design l Consider standard process in which the central manager subsidizes the construction cost, but not the maintenance costs –By direct payment or tax credits –Common in the United States –Also applies to private organizations (MIT, …) l What is the effect of such policies? l Favors technology that costs more at start

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 13 of 18 Effect of 50% Subsidy of Investment: breakeven point shifted from 3.5 to ~ 7%

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 14 of 18 Cost Advantage of Concrete (with 50% subsidy)

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 15 of 18 Lesson of Effect of Subsidy l Policies that affect only part of the cash flow, affect the relative merits of alternative technologies. l Subsidies on Construction costs favor more expensive investments l US Government pays States up to 90% of initial investment for Interstates l This is a major reason why Interstate System is built in concrete….

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 16 of 18 Importance of Life of Project (20 versus 40 highway life )

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 17 of 18 Lesson from alternative life of projects l Using higher discount rates makes events in distant future insignificant l Cut life of project in half (in example) changes Present value by a few percent –not significant in terms of accuracy of forecast estimates of costs, benefits l Exception: If Discount rates < 5% or so

Engineering Systems Analysis for Design Richard de Neufville © Massachusetts Institute of Technology Asphalt vs. Concrete Example Slide 18 of 18 Lessons from Example l Analyses simple, HOWEVER l Results depend highly on assumptions –About discount rate –About tax or subsidy incentives –Even about life of project l Designers of Tax, Economic Programs may be actual System Designers