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Engineering Economics

Dr. Karim

Chapter 4:
Inflation and Its Impact on Project

Inflation and Economic Analysis


What is inflation?

How do we measure inflation?


How do we incorporate the effect of inflation
in economic analysis?
3

What is Inflation?
Value of Money
Earning Power
Purchasing power

Earning Power
Investment Opportunity

Purchasing Power

inflation)

Decrease in purchasing power (


Increase in purchasing Power (deflation)

Purchasing Power
$100

$100
1990

1990

You could buy 50 Big Macs


in year 1990.
$2.00 / unit

25%
Price change
due to

2001

You can only buy 40 Big


Macs in year 2001.
$2.50 / unit

inflation
The $100 in year 2001 has only $80
value purchasing power of 1990
5

$100
-2

-1

$100
0

-2

You can now purchase


80 liters of unleaded gas.

You could purchase


63.69 liters of unleaded
gasoline a year ago.

$1.57 / gallon

-1

20.38%

$1.25 / gallon

Price change due to

deflation

Measuring Inflation
Consumer Price Index (CPI): the CPI
compares the cost of a sample market basket of
goods and services in a specific period relative to
the cost of the same market basket in an earlier
reference period. This reference period is designated
as the base period or base year.
Market basket
Base Period (1967)

2001

$100

$512.9
CPI for 2001 = 512.9
7

Price Increase Due to Inflation


(The annual percentage change in a CPI is used to measure inflation)
Item

1967 Price

2000 Price

% Increase

(Base Year)

512.9

[(512.9 -100) / 100] * 100 = 413 %

$114.31

$943.97

726 %

82.69

471.38

470 %

Loaf of bread

.22

1.84

736 %

Pound of hamburger

.39

2.98

564 %

Pound of coffee

.59

4.10

595 %

Candy bar

.10

0.90

[(0.9 0.1) /0.1] * 100 = 800 %

Mens dress shirt

5.00

39.00

680 %

Postage (first-class)

0.05

0.33

660 %

294.00

3,960.00

1,247 %

Consumer price index (CPI)

100

Monthly housing expense


Monthly automobile expense

Annual public college tuition

Average Inflation Rate (f)


Specific, individual commodities do not always reflect
the general inflation rate in their price changes. We
can calculate an average inflation rate (f ) for a
specific commodity (j) if we have an index (that is, a
record of historical costs) for that commodity.

Average Inflation Rate (f)


Fact:
Base Price = $100 (year 0)
Inflation rate (year 1) = 4%
Inflation rate (year 2) = 8%
Average inflation rate over 2 years?

Step 1: Find the actual inflated price at the end of year 2.


$100 ( 1 + 0.04) ( 1 + 0.08) = $112.32

Step 2: Find the average inflation rate by solving the


following equivalence equation.
2

$100 ( 1+ f) = $112.32
f = 5.98%

$112.32

1
2

$100
11

Average Inflation Rate (f)


Item
Consumer price index (CPI)
Monthly housing expense
Monthly automobile expense

1967 Price

100

2000 Price

Average Inflation
Rate

512.9

5.07%

$114.31 $943.97

6.61

82.69

471.38

5.42

Loaf of bread

0.22

1.84

6.64

Pound of hamburger

0.39

2.98

6.36

Pound of coffee

0.59

4.10

6.05

Candy bar

0.10

0.90

6.88

Mens dress shirt

5.00

39.00

6.42

Postage (first-class)

0.05

0.33

5.89

294.00 3,960.00

8.19

Annual public college tuition

12

Example : Yearly and Average Inflation Rates


Year

Cost

$504,000

538,000

577,000

629,500

What are the annual inflation rates (f1; f2; f3)


and the average inflation rate (f ) over 3 years?

Solution

Inflation rate during year 1 (f1):


[($538,400 - $504,000) / $504,000]* 100 = 6.83%.
Inflation rate during year 2 (f2):
[($577,000 - $538,400) / $538,400] * 100 = 7.17 %.
Inflation rate during year 3 (f3):
[($629,500 - $577,000) / $577,000] * 100 = 9.10%.
The average inflation rate over 3 years is
$504,000 ( 1+ f)3 = $629,500
f = 7.69 %
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Inflation Terminology - II
With inflation all dollars are not the same.
When inflation is considered in an economic analysis, money
is expressed by two measures: real and actual dollars.
We will see that either measure can be used for an analysis,
but it is important to understand the distinction between the
two.

Real and Actual Dollars


1- Actual / Current Dollars (An ): Estimates of future cash
flows for year n that take into account any anticipated
changes in amount caused by inflationary or deflationary
effects.

2- Constant / Real Dollars (An ): Estimates of future cash


flows for year n in constant purchasing power, independent
of the passage of time (base year dollars).

Conversion From Real / Constant to Actual Dollars


If we have a cash flow expressed in real dollars (base
year dollars), it is expressed in actual dollars by
inflating the amounts individually for each period.
we use the general inflation rate (f) as an inflation
factor.

Conversion From Real / Constant to Actual Dollars


_

An A' n (1 f ) A' n ( F / P, f , n)
$1,000

n3

$1,260

f 8%
3

Constant
Dollars

3
$1,000 (1 + 0.08)
= $1,260

Actual
Dollars

Conversion from Constant to Actual Dollars


Period

Net Cash Flow in


Constant $

Conversion
Factor

Cash Flow in
Actual $

-$250,000

(1+0.05)0

-$250,000

100,000

(1+0.05)1

105,000

110,000

(1+0.05)2

121,275

120,000

(1+0.05)3

138,915

130,000

(1+0.05)4

158,016

120,000

(1+0.05)5

153,154
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$100,000

$110,000

$120,000 $130,000
$120,000

$105,000

$121,275

$120,000(1+0.05)3

Years
(a) Constant dollars

5
$120,000(1+0.05)5

$130,000(1+0.05)4

$110,000(1+0.05)2

$250,000(1+0.05)0

$250,00
0

$100,000(1+0.05)

$138,915 $158,016
$153,154

0
1
$250,000

Years
(b) Actual dollars
20

Applied Example
A 25 year old college graduate has just been hired for her first job. She brags that she
will save enough money to retire at 55 with one million dollars. But wait. Lets
assume a 3% annual inflation rate over her 30 year career. If she wants her
retirement fund to have the value of one million of todays dollars, how much must
she save?
When the college student is planning for her retirement, she is probably thinking of the
1 million dollars in terms of todays dollars. If she could retire today, she thinks she
can live happily with 1 million dollars. But after 30 years, that amount will not buy
what it can today

How big must her retirement be in actual

dollars to have the spending power of 1 million of


todays real dollars?

Solution
The $1 million is in real dollars. Changing it to actual dollars
we find that she will have to save almost $2.5 million. She
will start spending her retirement money in 30 years. Money
spent is always measured in actual dollars. The actual dollar
equivalent assuming 3% inflation is almost $2.5 million
dollars = 1000000 (1+0.03)30 = 2427262.47$
Wouldnt she be disappointed if she only saved 1 million

??

Conversion from Actual to Constant Dollars


Our illustration is the same as the one used earlier except now
we start with the actual dollars. The amounts in each year
are deflated by the general inflation rate We use the
general inflation rate (f) as measured by the CPI in the
discount factor.
Of course, we obtain the uniform series that we started with.
We should note from our examples that the amount at time 0
did not change. Amounts at time 0 are the same in real or
actual dollars because there is no passage of time.

Conversion from Actual to Constant Dollars


_

A' n An (1 f ) An ( P / F, f , n)

$1,000

n3

$1,260

f 8%
3

Constant
Dollars

-3
$1,260 (1 + 0.08)
= $1,000

Actual
Dollars

Conversion from Actual to Constant Dollars


End of
period

Cash Flow
in Actual $

Conversion Cash Flow in


Loss in
at f = 5%
Constant $ Purchasing
Power

-$20,000

(1+0.05)0

-$20,000

0%

20,000

(1+0.05)-1

-19,048

4.76

20,000

(1+0.05)-2

-18,141

9.30

20,000

(1+0.05)-3

-17,277

13.62

20,000

(1+0.05)-4

-16,454

17.73
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Equivalence Calculation Under Inflation


1.
2.

Types of Interest Rate


Market Interest Rate (i)
Real Interest Rate (i)

Types of Cash Flow

In Constant / Real Dollars


In Actual / Current Dollars

3.

Types of Analysis Method


Constant Dollar Analysis
Actual Dollar Analysis
Deflation Method
Adjusted-discount method
26

Inflation Terminology - III


Interest rates for project evaluation may be stated in one of two forms:
Market / Nominal Interest Rate (i): A rate which combines the effects
of interest and inflation.
Real Interest Rate (i): A rate from which the effects of inflation have
been removed.
Real Interest Rate (i) = Nominal Interest Rate (i) General Inflation Rate (f )
Nominal Interest Rate(i) = Real Interest Rate (i) + General Inflation Rate (f )
= Market Interest Rate Under Continuous
Compounding
& Purchasing Power

It reflects both Earning Power

Actual & Constant Dollars


Project cash flows may be stated in one of two forms:
1- Actual / Current Dollars (An): Dollars that reflect
the inflation or deflation rate.
2- Constant / Real Dollars (An): Year 0 dollars

Inflation & Cash Flow Analysis


I - Actual / Current Dollar Analysis
- If the cash flow is estimated in terms of the dollars that will be used in
n years, we say the amounts are in actual (or year-n, or current) dollars.

II - Constant / Real Dollar Analysis


-If the cash flow is estimated in terms of constant-value dollars, we say
the amounts are in real (or year-0, or constant) dollars.

I-Actual / Current Dollars Analysis


To calculate the present value of actual dollars, we can use a twostep or a one-step method:

Deflation MethodTwo Steps:


1.Convert any cash flow elements in actual dollars into

constant dollars by deflating with the general inflation rate (f ).


2. Calculate the present value of constant dollars by discounting
at the real interest rate (i).
Adjusted-discount MethodOne Step:
1. Compute the nominal / market interest rate (i).
2. Use the market interest rate (i) directly to find the present
value.

Step 1:
Convert actual dollars to Constant dollars

Cash Flows in Actual Dollars

Multiplied by
Deflation Factor

Cash Flows in Constant


(or year 0) Dollars

-$75,000

-$75.000

32,000

(1+0.05)-1

30,476

35,700

(1+0.05)-2

32,381

32,800

(1+0.05)-3

28,334

29,000

(1+0.05)-4

23,858

58,000

(1+0.05)-5

45,445
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Step 2:
Convert Constant dollars to Equivalent Present value
n

Cash Flows in Constant (or


year 0) Dollars

Multiplied by
Discounting Factor

Equivalent Present
value

-$75,000

-$75,000

30,476

(1+0.10)-1

27,706

32,381

(1+0.10)-2

26,761

28,334

(1+0.10)-3

21,288

23,858

(1+0.10)-4

16,295

45,445

(1+0.10)-5

28,218
$45,268
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Deflation Method:
Converting actual dollars to constant dollars and then to equivalent
present value
n=0

Actual
Dollars

Constant
Dollars

Present
value

-$75,000

-$75,000

n=1

n=2

n=3

n=4

n=5

$32,000 $35,700 $32,800 $29,000 $58,000

$30,476

$32,381 $28,334 $23,858 $45,455

$28,218

-$75,000
$27,706

$26,761 $21,288

$16,295

$45,268
33

Method 2: Adjusted-Discount Method


Pn

An
(1 f ) n
Pn
(1 i ') n

Step 2

An
An

n
(1 i )
(1 f ) n (1 i' )

Step 1

(1 i ) (1 i )(1 i' )

An

(1 f ) n (1 i ' ) n

An
(1 i ) n

1 i' f i' f

An
(1 f ) (1 i' )
n

i i ' f i ' f
34

Adjusted-Discounted Method
n

Cash Flows in Actual Dollars

Multiplied
by

Equivalent
Present value

-$75,000

-$75,000

32,000

(1+0.155)-1

27,706

35,700

(1+0.155)-2

26,761

32,800

(1+0.155)-3

21,288

29,000

(1+0.155)-4

16,296

58,000

(1+0.155)-5

28,217
$45,268

P n = An / (1+i) n = An (1+i) - n
i i' f i' f
0.10 0.05 ( 0.10 )( 0.05)
15.5%

- $75,000
$27,706
$26,761
$21,288
$16,295
$28,218
= $32,000 (P/F,
15.5%, 1)

$35,700

3
4
= $58,000 (P/F, 15.5%, 5)

$32,800

= $29,000 (P/F, 15.5%, 4)

$32,000

= $32,800 (P/F,
15.5%, 3)

= $35,700 (P/F,
15.5%, 2)

Adjusted-discount method
$58,000

$29,000

0
5

$45,268
36

Adjusted Discount Method


Converting actual dollars to present value dollars by applying the
market interest rate

n=0

Actual
Dollars

-$75,000

n=1

n=2

n=3

n=4

n=5

$32,000 $35,700 $32,800 $29,000 $58,000

i i f if 15.5%

Present
value

$28,218

-$75,000
$27,706

$26,761 $21,288

$16,295

$45,268
37

II - Constant / Real Dollar Analysis


Two Steps Approach:
Step 1- Convert any cash flow elements in constant dollars
into actual dollars by using the general inflation rate (f ).
Step 2- Use the market interest rate (i) to find the equivalent
present value.

38

Example- Equivalence Calculation with Composite Cash Flow Elements:


Age

Saving for College

College expenses
(in todays dollars)

College expenses
(in actual dollars)

18 (Freshman)

$30,000

$30,000(F/P,6%,13) = $63,988

19 (Sophomore)

30,000

30,000(F/P,6%,14) = 67,827

20 (Junior)

30,000

30,000(F/P,6%,15) = 71,897

21 (senior)

30,000

30,000(F/P,6%,16) = 76,211

Note: saving begins when child is age 5, 13 years before entering college

Required Quarterly Contributions to College Funds

V1 = C(F/A, 2%, 48)


V2 = $229,211
Let V1 = V2 and solve
for C:
C = $2,888.48

40

Item
Rate of Return
and NPW

Effects of Inflation
Unless revenues are
sufficiently increased to keep
pace with inflation, tax effects
and/or a working capital drain
result in lower rate of return or
lower NPW.

41

Rate of Return Analysis under Inflation


_

f 10%

Principle:True (real) rate of


return should be based on
constant dollars.
If the rate of return is
computed based on actual
dollars, the real rate of
return can be calculated as:
i'

1 i
_

1 f
1 0.3134

1
1 0.10
19.40%

Net cash
flows in
actual
dollars

Net cash
flows in
constant
dollars

0
1
2
3
4

-$30,000
13,570
15,860
13,358
13,626

-$30,000
12,336
13,108
10,036
9,307

IRR

31.34%

19.40%

Not correct IRR


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