Inflation and relative price

changes.
Some further complications for
project appraisal.
 Inflation
• Inflation is a general upward movement of some
measure of an ‘average’ price level.RPI CPI etc.
• The average price level is determined on the basis of
some agreed representative weighted ‘bundle of goods
and services’. Over time the ‘bundle’ itself will change
reflecting changes in patterns of consumption.
• Within that ‘bundle’ individual components will
experience different % price changes some rising faster
than others and some may be actually falling even in
nominal terms.
• It is measured as a % yearly increase and hence
described as an inflation rate.
• Each of us experiences a unique personal rate of
inflation due to individual patterns of consumption hence
a range of measures eg retail price index, wholesale
price index consumer price index etc.
• Inflation drives a wedge between nominal and real
values and there is frequently a need to ‘deflate’ nominal
values to eliminate the impact of price rises.
 cont

• Since nominal GDP (itself a rate ie output per

year) involves summing up the product of PxQ
the result includes the effects of both changes in
real output (Q) but also price changes (P) and
the role of a deflator is to eliminate the impact
price changes has on the total, thus leaving only
real ie quantity changes.
• Deflators in effect ‘re-price’ successive years
output at some earlier datum years prices.
• Over time the composition of the typical
consumption bundle changes as does the
relative significance of individual items and this
requires periodic adjustments to reflect this.
• No single measure can capture all the relevant
information and different groups in society
experience very different ‘costs of living’. Lower
income groups are more vulnerable to changes
in the prices of essentials thus eg fuel poverty.
 The Implications for Project Appraisal.
• Inflation impacts upon interest and hence discount rates
resulting in nominal and real discount rates diverging. (It
also has a similar impact on exchange rates although
here it is differential inflation that now matters).
• The basic relationship is given by the ‘Fisher Equation’
(1+ i) = (1+r)(1+f) where i= the nominal interest rate, r=
real rate of interest and f= inflation rate , all as fractions.
• Solving the Fisher equation for r gives us the following
r= (i – f)/( 1+f)
• Note that if f=0 then i=r and also that when f is small then
r~ (i-f).
• If f>i then r is negative implying that ‘saving is making
you worse off’ since prices are escalating out of reach
despite positive nominal interest rates.
• Taxation of nominal interest i makes the possibility of
negative real after tax returns more likely. If the tax
rate=t then after tax nominal interest =i(1-t) from which
the rate of inflation has also to be deducted.
 PRICE CHANGES
• It is unlikely that a specific project will be made
up of components that mirror inflation since the
project will typically consume a specific range of
inputs each of which will have its own price rise.
Some may escalate at higher rate than others.
• The basic ‘Fisher Equation’, slightly
reformulated, can be used to distinguish
between real and nominal proportional price
changes.
• (1+Pn)= (1+Pr)(1+f) hence
• Pr= (Pn-f)/(1+f) Note that Pr may be positive, a
real increase, or negative a real price decrease.
• A % price rise in nominal terms that just matches
the inflation rate leaves the price constant in real
terms.
 Cont.
• A constant proportional price change (p)
can be combined with a discount rate ( r)
to produce a net discount rate but care
needs to be taken to ensure that both are
nominal OR both are real.
• The algebra for this was in the first tutorial.
• If the discount rate and rate of price
change were equal the effects would
cancel out.
• To a first approximation the net effect
would be a discount rate = r - p
 How do we apply this?
• One word CONSISTENCY, is the answer.
• EITHER everything in real terms OR every thing in
nominal terms; no exceptions.
• By everything we mean BOTH the cash flows AND the
discount rates.
• Real cash flows should be discounted by the real
discount rate.
• Nominal cash flows should be discounted using the
nominal discount rate.
• NEVER EVER CROSS MATCH!
• The choice as to whether to work in real or nominal
terms depends upon convenience. If most data is
nominal then nominal may be best. Whichever you
choose you will get the same answer; can you see
why!?
Comparing Options with different life times.
• Comparison must be valid ie calculated on a
consistent basis.
• If an indefinitely long period is envisaged with
multiple cycles of replacement, then the option
with the lowest average annual cost is the
cheapest option. This can be calculated for one
cycle and the cheapest option selected.
• If say a 12 year period is involved then 4x3 =3x4
etc to ‘co-terminate’ at the same point in time.
• If however a 13 year period for the above was
required there is no ‘neat’ solution and the issue
of residual value of equipment with some useful
life becomes important.
• Note also that technological change is also
potentially a complication in replacement
decisions.
 Tax and depreciation.
• The net income of firms is usually subject to tax in the
form of a ‘corporation tax’.
• Tax is levied on taxable profit.
• Tax authorities permit certain allowable expenses to be
offset against profit thus reducing liability for taxation.
• Depreciation of capital equipment represents one
important example of an allowable cost that may reduce
profit for tax liability purposes.
• The tax authorities determine depreciation allowances
on a ‘formulaic’ basis as opposed to the economic
concept based upon market prices.
• Linear ie straight line or declining balance (constant %)
depreciation schedules are the most commonly used.
Special ‘accelerated’ depreciation is used as an
incentive.
 Cont.
• Interest charges on debt ie borrowed money is
another allowable cost for tax purposes and the
tax issues give rise to debates regarding optimal
capital structure ie the respective roles of debt
and equity (Modigliani-Miller).
• It is also sometimes possible to consolidate
accounts which is advantageous in that it
permits losses incurred in one company to be
offset against profits in another, something
denied to a stand alone company.
• The choice of where to declare profit is currently
controversial and increasingly viewed as
evasion rather than avoidance.