Selection of Interest and Inflation Rates for Infrastructure Investment Analyses

Engineering economic analyses (EEA) apply economic methodologies to engineering problems for decision-making support. 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. 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 South Dakota Department of Transportation (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 may be debatable because the price of materials and labor can vary by type and area. In this research, 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 Life Cycle Cost Analysis (LCCA) studies; and the composition of the South Dakota Construction Cost Index (SDCCI) was re-examined and modified. 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.