The Challenge
Abstract: When AM was new, and practitioners were curious, I introduced the ‘back page case study’ challenge in AMQ. This was the first one.
“George Netherby, the Chief Engineer at Clena Waterways, was delighted. The new cathodic protection results were excellent. For only $100m, the bulk of the agency’s pipelines, which were about 40 years old, could be extended out to 160 years, instead of their current 80-year design and economic life. Triumphantly, he took the new results to Anna Burnside, the agency's accountant, and suggested that a budget submission for the $100m be submitted forthwith. Anna did not share his rejoicing. She explained that with the cathodic protection, the asset values would increase from their current value of 50% of 4 billion (their current replacement value) to 75%, an increase of 1 billion dollars. Great! said George, beaming. Not so great! replied Anna, your cathodic protection will not increase my net revenues; in fact, they will decrease them by $100m, and with the same, or declining revenues, and an increasing asset base, the rate of return, the key performance indicator for this agency, will decline. Sorry, George, it's not on.
You are called in to advise. What do you say to George and Anna? Does your answer vary if Clena Waterways is a private company or a government agency?”
Some respondents submitted thoughtful, analytical responses, such as:
“George Netherby's proposition is to spend $100 million now to avoid spending $ 4,000 million in 40 years. I suggest that we compare the value of $100 million invested for 40 years with the $4,000 million to be spent in 40 years. In constant dollars (that is, assuming no inflation), the value of a range of real interest rates indicates that for real interest rates below 10%, it is better to spend the $100m as proposed rather than invest it.
This raises the question of the reliability of other assumptions, such as whether the pipes (if not given cathodic treatment) would need to be replaced significantly earlier or later than 40 years from now. For example, if all other things were as assumed but replacement was, in the event, not required until 50 years from now, then it would be better to invest $100 million rather than spend it on the proposed project if the real interest rate for the
period is greater than 7.5%. On the other hand, if the pipes had to be replaced in 30 years, the project would be a good investment for any conceivable real interest rate.”
Others had a bit more fun with their submissions.
“Advice to George and Anna
1. Dump the cathodic protection and install state-of-the-art anodic destruction technology, which will corrode the pipelines away in 20 years. Their residual value will halve, Clena's rate-of-return performance indicator will experience a spectacular rise, and George and Anna will both receive big bonuses.
2. Go ahead with the cathodic protection. 40 years ago, Clena Waterways built the pipelines with capital borrowed from the World Bank. The loan runs for 80 years - the projected life of the asset. Clena's consumer charges have been set to cover the capital and interest repayments. Now that the loan can be restructured over a much longer period, it can readily be demonstrated that consumers have been grossly overcharged. George and Anna should take the story to the media. The Minister for Wet and Dry will be forced to resign, and the consumers will all get a windfall cash reimbursement. George and Anna will be elected to Parliament on a tidal wave of popular acclaim.
3. Clena should enter into a sale and lease-back arrangement with Mega National Investments. Mega National will purchase at valuation ($2 billion), install the cathodic protection ($100 million), then on-sell the asset to Ultra Global at its revised valuation ($3 billion + $100 million). Mega National's profit will be $ 1 billion, of which a mere 1 per cent ($10 million) will be due to George and Anna as their consultancy fee. They can run away together and live happily ever after in a villa in Majorca.”
Both submissions won the prize of half a dozen premium South Australian reds, the first for analysis, the second for style.