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ECO 1192
Lecture 9: Decision-making with Price Changes
Claude Thoret
University of Ottawa
Recommended Reading
Fraser et al. Chapter 9
Newnan et al. chapter 14
9. Price Changes
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Introduction
In all project analyses thus far, the prices of
9. Price Changes
Measuring Inflation
Consumer Price Index
basket of consumer goods and services used
to track changes in prices on a monthly basis
Wholesale Price Index (tracks the prices of
wholesale goods)
GDP Implicit Price Deflator (tracks price
changes for all final goods and services
produced by an economy)
Published quarterly and annually
9. Price Changes
9. Price Changes
Your house .
1.
2.
3.
4.
= $225,000(1+inflation rate)-15
= $225,000(1+0.02)-15 = $167,178
Answer: YES (real value in 2005 > real value in 1990).
9. Price Changes
105.8
9. Price Changes
10
Causes of Inflation
Money supply
Growth in the money supply (currency and bank
deposits) exceeds the growth of goods and services
Exchange rates
Value of one currency in terms of another currency;
changes may affect the cost of purchasing goods and
services from other countries
Cost-push inflation
Increases in production costs (wages) higher prices
Demand pull inflation
the demand for goods and services grows faster than
their production
9. Price Changes
11
12
13
Is Inflation problematic?
Yes. Unpredictable changes in the inflation rate
14
Rates of interest
Nominal (or actual)
Combination of the real rate and the rate of
inflation
Real (or constant)
Inflation-free rate of interest
In a zero (no) inflation world, the minimum rate
required for you to substitute future
consumption for current consumption
15
reference year
Note that base year dollars can be stated as real or
constant dollars (for example, year 2000 dollars)
Non base-year dollars (such as year 2001 dollars)
can be stated as nominal or current dollars
For the base year, the PW of real dollars (inflationfree dollars) will equal the PW of nominal dollars
(dollars containing inflation)
See next slide for the conversion of nominal dollars
for any year (other than the base year) to equivalent
real dollars (i.e., inflation-free dollars)
9. Price Changes
16
17
You invested $1,000 in a GIC from the Trust Me Company exactly five
years ago today.
No annual interest was paid to you over the years as the interest
income was reinvested automatically by the financial institution.
Today, you received a cheque for $1,500 which represents
The reimbursement off the $1,000 invested 5 years ago
Interest income generated by your $1,000 investment
If inflation was 4% throughout the 5 years, what is the purchasing
power of the $1,500 today relative to their purchasing power 5 years
ago?
= 1,500(P/F,inflation rate, 5) = 1,500(P/F,4%,5)
= $1,232.89
$1,500 is required today to buy what $1,232.89 could buy 5 years
ago (or about 83%); or
$1,217 is required today to buy what $1,000 could buy 5 years ago.
9. Price Changes
18
without risk = 5%
First cost (P) = $3,000 on
January 1, 2001 (same as
December 31, 2000)
Cash flows in January 1,
2001 dollars (i.e., real or
constant dollars)
Real interest rate
= 5% - 3% = 2%
9. Price Changes
December
31
Cash Flows
2000
-3 000
2001
+1 500
2002
+1 500
2003
+1 500
2004
+1 500
19
without risk = 5%
First cost (P) = $3,000 on
January 1, 2001 (same as
December 31, 2000)
Cash flows in actual
dollars (i.e., at the
prevailing price of each
year)
9. Price Changes
December
31
Cash Flows
2000
-3 000
2001
+1 500 (1.03)
= 1 545
2002
+1 500 (1.03)2
= 1 591
2003
+1 500 (1.03)3
= 1 639
2004
+1 500 (1.03)4
20
= 1 689
Example
An investor wants a real return (i.e., inflation-free return) of 4%
21
compounded annually
22
(ir)?
(1+ic) = (1+ir)(1+f); (1+ir) = (1+ic)/(1+f)
ir = (1+ic)/(1+f) 1
= [(1+0.055)/(1+0.02)] - 1
= 0.0343 or 3.43% (precise rate)
9. Price Changes
23
9. Price Changes
24
Cash Flows
Current $
Discount
Rate (%)
Current
(nominal)
Constant
(real)
Approximate
= (1+f)(1+r) 1
=r+f
= [(1+c)/(1+f)] -1
=cf
Constant $
Current
Constant
X
9. Price Changes
25
Your turn!!!!
Determine the rate of inflation during a
26
Your turn!!!!
Determine the rate of inflation during a
Your turn!!!!
During a specific 5-year period, the market
28
Your turn!!!!
During a specific 5-year period, the market
29
Example 1
P = 1,000; F = 2,000; N = 4 years;
f = 10% (inflation rate); tax rate (t) = 0 (No taxes)
Find i c and i r
From F = P(1+ic)N
2000/1000 = (1+ic)4
Solve for ic: ic = 0.189 or 18.9% (with inflation)
From ir = [(1 +ic) /(1 + f)] - 1
= [(1+0.189)/(1+0.1)] - 1 = 0.081 or 8.1% (inflationfree)
9. Price Changes
30
Example 2
Assume that $5,000 is deposited each year-end in an
account earning interest at 10 percent per year
over a 5-year period. During this period, inflation is
expected to remain at 6 percent per year.
Determine the dollar amount in the fund at the end
of five years (the future worth after five years in
actual dollars)?
Future Worth = 5000(F/A,10%,5)
= $30,525 (actual or current dollars i.e., in dollars 5
years from now)
9. Price Changes
31
Example 2 (contd)
Given the eroding effect of inflation on
purchasing power, what is the value of this fund
in constant (real) dollars after five years?
$30,525(P/F,inflation,5)
= 30,525(P/F,6%,5)
= $22,810 [inflation-free dollars]
9. Price Changes
32
Example 2 (contd)
What is the real (inflation-free) rate of return on
this investment?
Real interest rate = ir = [(1 +ic)/(1 + f)] - 1
= [(1+0.1)/(1+0.06)] - 1
= 0.03774 or 3.774%
(the rate at which the investors purchasing power
increased during the 5-year period)
9. Price Changes
33
Example 3
Engineering Press is offering several subscription packages to
9. Price Changes
34
Example 3 (contd)
Year
Option 1
Option 2
Option 3
40
74
109
42
--
--
44.10
81.59
--
46.31
--
126.18
48.62
89.95
--
51.05
--
--
9. Price Changes
35
Example 3 (contd)
Find the PW of each subscription option:
Annual subscription : 40+42(P/F,10%,1)
+44.102(P/F,10%,2)+46.31(P/F,10%,3)
+48.62(P/F,10%,4)+51.05(P/F,10%,5)
= $214.32 (most expensive as expected)
Two-year subscription:
74 +81.59(P/F,10%,2)+89.95(P/F,10%,4)
= $202.87 (best deal)
Three-year subscription: 109+126.18(P/F,10%,3)
= $203.80
9. Price Changes
36
Example 4
Exactly 75 years ago today, Farmer Billy
37
Example 4 (contd)
Instead of storing $1,000 in a bag of wheat,
= $79,057
Real-dollar value = 79,057(P/F,inflation,75)
= $2,036 [Which is much better than $25.75]
GIC Guaranteed Investment Receipt
9. Price Changes
38
Example 4 (contd)
Instead of storing the $1,000 in a bag of wheat or
= $4,913,056
Real-dollar value = 4,913,056(P/F,inf,75)= $126,519
[Which is much better than $25.75 in the bag of wheat
and $2,036 in a GIC]
9. Price Changes
39
Cash Flows
Key issue: are cash flows
Annual receipts
Annual operating and maintenance costs
rate.
9. Price Changes
40
Example 5
Annual Interest Income
= 1,000@15% = $150
Inflation is 10% annually
$1,000 bond investment is fully refunded
(without risk of default) after 3 years
N = 3 years
Find ic and ir
9. Price Changes
41
Example 5 (contd)
Using the Present Worth Approach:
1000 = 150(P/A,i*,3)+ 1000(P/F,i*,3)
Solve for i*: i* = 15% (=ic)
From ir = [(1 +ic) / (1 + f)] 1, ir
= [(1 +0.15) / (1 + 0.1)] 1
= 0.0455 or 4.55%
9. Price Changes
42
ir = (1 +ic) /(1 + f) - 1
ir = (1 +0.105) /(1 + 0.1) - 1
ir = 0.0045 or 0.45%
43
Example 6
A = Annual interest income is fully responsive
to inflation
Inflation (f) = 10%
P = $1,000 which is also fully responsive to
inflation
F = $1,000
N = 3 years
Find ic and ir
9. Price Changes
44
Example 6 contd
Using the Present Worth Approach
1000 = 150(1+f)(P/F,i*,1)
+ 150(1+f)2(P/F,i*,2)
+ 150(1+f)3(P/F,i*,3) + 1000(1+f)3(P/F,i*,3)
Solve for i*: i* = 26.5% (=ic)
From ir = (1 +ic) /(1 + f) - 1
ir = (1 +0.265) /(1 + 0.1) - 1
= 0.15 or 15.0%
9. Price Changes
45
9. Price Changes
46
Cost of College
(Actual College Year
Dollars)
PW
(at the beginning of the First
College Year)
First
9000(F/P,8%,10) = $19,431
19,431(P/F,12%,0) = $19,431
Second
9000(F/P,8%,11) = 20,985
20,985(P/F,12%,1) = 18,737
Third
9000(F/P,8%,12) = 22,664
22,664(P/F,12%,2) = 18,068
Fourth
9000(F/P,8%,13) = 24,477
24,477(P/F,12%,3) = 17,422
TOTAL = $87,557
TOTAL = $73,658
9. Price Changes
47
purchasing power
Offer B: $49,000 the first year followed by
annual increases of $3,000
Offer C: $55,000 annually for the next 5 years
9. Price Changes
48
years
9. Price Changes
49
50
9. Price Changes
51
52
9. Price Changes
53
BTCF
real
Interest
on
Debt
AED
Taxable
Income
Income
Taxes
ATCF
nominal
ATCF
real
0
-2991
-2991
--
--
--
-2991
-2991
1100
1000
598
502
251
849
771.7
1210
1000
598
612
306
904
747.1
1331
1000
598
733
367
964
724.3
1464
1000
598
866
433
1031
704.2
1611
1000
598
1013
507
1104
685.5
NO
DEBT
9. Price Changes
AED = Annual
Equivalent Depreciation
54
9. Price Changes
55
BTCF
nom
(1)
BTCF
Real
(2)
Int.
on
Debt
(3)
Annual
Dep.
(4)
TI
(5)
IT
(6)
ATCF
Nom.
(7)
ATCF
Real
(8)
Debt
+
Princ
(9)
-2991
-2991
--
--
--
--
-2991
-2991
1100
1000
107.64
598
394
197
903
1210
1000
86.11
598
526
263
1331
1000
64.58
598
668
1464
1000
43.06
598
1611
1000
21.53
598
CFOE
Nom
(10)
CFOE
Real
(11)
--
2093.7
2093.7
820.9
287
616
560
947
782.6
265
682
563
334
997
749.1
244
753
566
823
412
1052
718.5
222
830
567
991
496
1115
692.3
201
914
568
56
B. After-tax
nominal rate of return = 19%
Real rate of return = 8%
C. Owner Equity
Nominal rate of return = 22%
Real rate of return = 11%
9. Price Changes
57
9. Price Changes
58
9. Price Changes
59
Investment Project
A firm is considering the purchase of a truck
9. Price Changes
60
Investment Project
1.
2.
3.
4.
5.
6.
7.
8.
9.
61
Investment Project
The firm gets a $100,000 loan (at a 10% rate of interest)
which is repaid as follows:
Year-end Repayment
Year 1 : 30%
Year 2 : 30%
Year 3 : 40%
9. Price Changes
62
Years
Item
1. BTCF (Actual $)
300,000
175,000
175,000
175000+
100000
2. BTCF (Constant $)
300,000
166,667
158,730
237,555
3. Interest on Loan
10,000
7,000
4,000
4. Depreciation
75,000
56,250
42,188
5. Taxable Income
90,000
111,750
128,812
6. Taxes Payable
45,000
55,875
64,406
110,594
+71,093.7
=181,687.7
7. ATCF (Actual $)
300,000
130,000
119,125
8. ATCF (Constant $)
300,000
123,810
108,050
156,948.7
9. Repayment of Loan
30,000
30000
40,000
3. Interest on Loan
10,000
7000
4,000
200,000
90,000
82125
112,948.7
200,000
9. Price Changes
85,714
74,49063
97,569.3
ROW
2. BTCF (Constant $)
3. Interest on Loan
4. Depreciation
5. Taxable Income
6. Taxes Payable
7. ATCF (Actual $)
8. ATCF (Constant $)
9. Repayment of Loan
10
11
3. Interest on Loan
10. CFOE (Actual $)
11. CFOE (Constant $)
64
65
IRR (%)
43
37
19
14
19
14
9. Price Changes
66
9. Price Changes
67
68
70
Mary bought a five-year $10,000 Guaranteed Income Certificate (GIC) on January 1, 2007 (for which
she paid $10,000).
The GIC pays $1,000 in interest income each year on December 31, 2007 to December 31, 2011
giving Mary a 10% rate of return on her investment.
On December 31, 20011 (the GICs maturity date), Mary will receive, in addition to her last interest
payment of $1,000, the full amount (i.e, $10,000) that she invested on January 1, 2007.
During this period, inflation is expected to be 5 percent per year.
9. Price Changes
71
Mary bought a five-year $10,000 Guaranteed Income Certificate (GIC) on January 1, 2007 (for which
she paid $10,000).
The GIC pays $1,000 in interest income each year on December 31, 2007 to December 31, 2011
giving Mary a 10% rate of return on her investment.
On December 31, 20011 (the GICs maturity date), Mary will receive, in addition to her last interest
payment of $1,000, the full amount (i.e, $10,000) that she invested on January 1, 2007.
During this period, inflation is expected to be 5 percent per year.
9. Price Changes
72
Mary bought a five-year $10,000 Guaranteed Income Certificate (GIC) on January 1, 2007 (for which
she paid $10,000).
The GIC pays $1,000 in interest income each year on December 31, 2007 to December 31, 2011
giving Mary a 10% rate of return on her investment.
On December 31, 20011 (the GICs maturity date), Mary will receive, in addition to her last interest
payment of $1,000, the full amount (i.e, $10,000) that she invested on January 1, 2007.
During this period, inflation is expected to be 5 percent per year.
9. Price Changes
73
Mary bought a five-year $10,000 Guaranteed Income Certificate (GIC) on January 1, 2007 (for which
she paid $10,000).
The GIC pays $1,000 in interest income each year on December 31, 2007 to December 31, 2011
giving Mary a 10% rate of return on her investment.
On December 31, 20011 (the GICs maturity date), Mary will receive, in addition to her last interest
payment of $1,000, the full amount
(i.e,
$10,000) that she invested on January 1,
9. Price
Changes
742007.
During this period, inflation is expected to be 5 percent per year.
Mary bought a five-year $10,000 Guaranteed Income Certificate (GIC) on January 1, 2007 (for which
she paid $10,000).
The GIC pays $1,000 in interest income each year on December 31, 2007 to December 31, 2011
giving Mary a 10% rate of return on her investment.
On December 31, 20011 (the GICs maturity date), Mary will receive, in addition to her last interest
payment of $1,000, the full amount (i.e, $10,000) that she invested on January 1, 2007.
During this period, inflation is expected to be 5 percent per year.
9. Price Changes
75
Mary bought a five-year $10,000 Guaranteed Income Certificate (GIC) on January 1, 2007 (for which
she paid $10,000).
The GIC pays $1,000 in interest income each year on December 31, 2007 to December 31, 2011
giving Mary a 10% rate of return on her investment.
On December 31, 20011 (the GICs maturity date), Mary will receive, in addition to her last interest
payment of $1,000, the full amount (i.e, $10,000) that she invested on January 1, 2007.
During this period, inflation is expected to be 5 percent per year.
9. Price Changes
76
9. Price Changes
77
Engineering Economics
ECO 1192
Lecture 9: Decision-making with price changes
Claude Thoret
University of Ottawa