Chapter 11 Inflation and Its Impact on Project Cash Flows

Slides:



Advertisements
Similar presentations
Lecture No. 36 Chapter 11 Contemporary Engineering Economics Copyright © 2010 Contemporary Engineering Economics, 5th edition, © 2010.
Advertisements

1 Project Cash Flow Analysis Lecture No. 27 Professor C. S. Park Fundamentals of Engineering Economics Copyright © 2005.
Contemporary Engineering Economics, 4 th edition, © 2007 Effects of Inflation on Project Cash Flows Lecture No. 45 Chapter 11 Contemporary Engineering.
Contemporary Engineering Economics, 4 th edition, © 2007 Equivalence Calculation under Inflation Lecture No. 44 Chapter 11 Contemporary Engineering Economics.
IEN255 Chapter 11 - Inflation
CHAPTER 8 PRICE CHANGES and ECHANGE RATES. Definitions Inflation –An increase in the average price paid for goods and services bringing about a reduction.
Contemporary Engineering Economics, 4 th edition, © 2007 Meaning and Measure of Inflation Lecture No. 43 Chapter 11 Contemporary Engineering Economics.
(c) 2001 Contemporary Engineering Economics 1 Chapter 13 Inflation and Its Impact on Project Cash Flows Meaning and Measure of Inflation Equivalence Calculations.
Engineering Economics in Canada Chapter 9 Inflation.
(c) 2001 Contemporary Engineering Economics 1 Chapter 13 Inflation and Its Impact on Project Cash Flows Meaning and Measure of Inflation Equivalence Calculations.
Lecture No. 35 Chapter 11 Contemporary Engineering Economics Copyright © 2010 Contemporary Engineering Economics, 5th edition, © 2010.
Advanced Engineering Economy Contemporary Engineering Economics, 5th edition, © 2010.
L13: Equivalence Calculations under Inflation
Lectures in Engineering Economy Prof. Corrado lo Storto DIEG, Dept. of Economics and Engineering Management School of Engineering, University of Naples.
Capital Budgeting and Financial Planning Course Instructor: M.Jibran Sheikh Contact info:
L11: Measure of Inflation ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences.
Lecture No. 37 Chapter 11 Contemporary Engineering Economics Copyright © 2010 Contemporary Engineering Economics, 5th edition, © 2010.
Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Meaning and Measure of Inflation.
Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Effects of Inflation on Project Cash.
Inflation / Deflation Inflation is an increase over time in the price of a good or service with a constant value A gallon of 87 octane gasoline increases.
Chapter 12 Inflation Effects.
1 Inflation ©2006 South-Western College Publishing.
1 Developing Project Cash Flow Statement Lecture No. 23 Chapter 9 Fundamentals of Engineering Economics Copyright © 2008.
Contemporary Engineering Economics, 4 th edition, © 2007 When Projects Require Only Operating and Investing Activities Lecture No. 39 Chapter 10 Contemporary.
Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Equivalence Calculation Under Inflation.
L12: Actual and Constant Dollars ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences.
Chapter Inflation and Capital Investment Analysis
Chapter 9 Project cash flow analysis 1.Understanding project cost elements 2.Why use cash flow in economic analysis 3.Income-tax rate to use in economic.
1 Chapter 4 Equivalence Calculations Under Inflation.
Inflation Don’t put your money in your mattress. Topics for today The reasons for inflation and its effect on prices Expressing cash flows in real or.
 2012 Pearson Education, Inc. Slide Chapter 13 Personal Financial Management.
Correcting Stats for Inflation CHAPTER 13 SECTION 2.
1 Chapter 9 Project Cash Flow Analysis. 2 Project Cost Elements Cost data is required to prepare external reports (historical cost data) make decisions.
Copyright © 2015, 2011, and 2007 Pearson Education, Inc. 1 Chapter 13 Personal Financial Management.
Effects of Inflation on Project Cash Flows
©2002 South-Western College Publishing
Equivalence Calculation under Inflation
APPLICATIONS OF MONEY-TIME RELATIONSHIPS
INVESTMENT ANALYSIS OR CAPITAL BUDGETING
Inflation and Its Effects on Project Cash Flows
Financial Analysis Lecture 4 (4/12/2017).
Correcting Stats for Inflation & Aggregate Supply and Demand
Facing Economic Challenges
Project Cash Flow Analysis
©2005 South-Western College Publishing
Mr. Mayer AP Macroeconomics
Lecture slides to accompany
Meaning and Measure of Inflation
Correcting Stats for Inflation & Aggregate Supply and Demand
Chapter 12 Inflation Effects.
Project Cash Flow Analysis
Price Changes and Exchange Rates
Measuring the Cost of Living
Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Meaning and Measure of Inflation Lecture.
Chapter 3.
The Consumer Price Index (CPI)
Prices in Grandma’s Day
Correcting Statistics for Inflation
EQUIVALENCE CALCULATIONS UNDER INFLATION
EQUIVALENCE CALCULATIONS UNDER INFLATION CHAPTER 4
Inflation.
INTERNATIONAL INSTITUTE OF IFORMATION TECHNOLOGY, (I²IT)
Chapter 8: Price Changes and Exchange Rates
INFLATION.
Inflation Part II.
Chapter 8: Price Changes and Exchange Rates
Outline Questions? News? Quiz Results Go over Quiz Go over Homework
CTC 475 Review Replacement Analysis Insider View
© 2007 Thomson South-Western
Chapter 4 Measure of Inflation
Presentation transcript:

Chapter 11 Inflation and Its Impact on Project Cash Flows Meaning and Measure of Inflation Equivalence Calculations under Inflation Effects of Inflation on Project Cash Flows Rate of Return Analysis under Inflation (c) 2001 Contemporary Engineering Economics

Inflation and Economic Analysis What is inflation? How do we measure inflation? How do we incorporate the effect of inflation in economic analysis? (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics What is Inflation? Value of Money Earning Power Purchasing Power Earning Power Purchasing power Investment Opportunity Decrease in purchasing power (inflation) Increase in purchasing Power (deflation) (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics Purchasing Power 1990 $100 1990 2001 You could buy 50 Big Macs in year 1990. You can only buy 40 Big Macs in year 2001. 25% $2.00 / unit $2.50 / unit Price change due to inflation The $100 in year 2001 has only $80 worth purchasing power of 1990 (c) 2001 Contemporary Engineering Economics

You could purchase 63.69 gallons of unleaded gasoline $100 $100 -2 -1 0 1 -2 -1 0 1 You could purchase 63.69 gallons of unleaded gasoline a year ago. You can now purchase 80 gallons of unleaded gas. 20.38% $1.57 / gallon $1.25 / gallon Price change due to deflation (c) 2001 Contemporary Engineering Economics

Price Increase Due to Inflation Item 1967 Price 2000 Price % Increase Consumer price index (CPI) 100 512.9 413 Monthly housing expense $114.31 $943.97 726 Monthly automobile expense 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 0.90 800 Men’s dress shirt 5.00 39.00 680 Postage (first-class) 0.05 0.33 660 Annual public college tuition 294.00 3,960.00 1,247 (c) 2001 Contemporary Engineering Economics

Inflation Terminology - I Producer Price Index: a statistical measure of industrial price change, compiled monthly by the BLS, U.S. Department of Labor Consumer Price Index: a statistical measure of change, over time, of the prices of goods and services in major expenditure groups—such as food, housing, apparel, transportation, and medical care—typically purchased by urban consumers Average Inflation Rate (f): a single rate that accounts for the effect of varying yearly inflation rates over a period of several years. General Inflation Rate ( ): the average inflation rate calculated based on the CPI for all items in the market basket. (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics 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. Market basket Base Period (1967) 2001 $100 $512.9 CPI for 2001 = 512.9 (c) 2001 Contemporary Engineering Economics

Selected Price Indexes Year Base Period New CPI 1982-84 Old CPI 1967 Gasoline 1982 Steel Passenger Car 1991 135.2 405.1 66.9 110.6 124.2 1992 139.5 417.9 65.6 107.1 127.3 1993 144.0 461.2 67.9 106.7 129.8 1994 147.4 441.4 59.5 111.9 133.3 1995 152.2 455.0 67.7 121.7 134.0 1996 156.6 468.2 76.4 114.9 1997 160.2 479.7 72.7 116.4 1998 162.5 487.1 54.0 115.4 132.2 1999 166.2 497.8 64.4 105.3 121.4 2000 171.2 512.9 92.6 109.8 133.4 (c) 2001 Contemporary Engineering Economics

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. $100 ( 1+ f) = $112.32 f = 5.98% $100 $112.32 0 1 2 2 (c) 2001 Contemporary Engineering Economics

Average Inflation Rate Item 1967 Price 2000 Price Average Inflation Rate Consumer price index (CPI) 100 512.9 5.07% Monthly housing expense $114.31 $943.97 6.61 Monthly automobile expense 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 Men’s dress shirt 5.00 39.00 6.42 Postage (first-class) 0.05 0.33 5.89 Annual public college tuition 294.00 3,960.00 8.19 (c) 2001 Contemporary Engineering Economics

Average inflation rate based on the CPI General Inflation Rate (f) Average inflation rate based on the CPI (c) 2001 Contemporary Engineering Economics

Example 13.2: Yearly and Average Inflation Rates Cost $504,000 1 538,000 2 577,000 3 629,500 What are the annual inflation rates and the average inflation rate over 3 years? Solution Inflation rate during year 1 (f1): ($538,400 - $504,000) / $504,000 = 6.83%. Inflation rate during year 2 (f2): ($577,000 - $538,400) / $538,400 = 7.17 %. Inflation rate during year 3 (f3): ($629,500 - $577,000) / $577,000 = 9.10%. The average inflation rate over 3 years is (c) 2001 Contemporary Engineering Economics

Inflation Terminology – II Actual 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. Constant Dollars (An’ ): Estimates of future cash flows for year n in constant purchasing power, independent of the passage of time (or base period). (c) 2001 Contemporary Engineering Economics

from Constant to Actual Dollars Conversion from Constant to Actual Dollars $1,260 $1,000 3 3 Actual Dollars Constant Dollars $1,000 (1 + 0.08) = $1,260 3 (c) 2001 Contemporary Engineering Economics

Conversion from Constant to Actual Dollars Period Net Cash Flow in Constant $ Conversion Factor Cash Flow in Actual $ -$250,000 (1+0.05)0 1 100,000 (1+0.05)1 105,000 2 110,000 (1+0.05)2 121,275 3 120,000 (1+0.05)3 138,915 4 130,000 (1+0.05)4 158,016 5 (1+0.05)5 153,154 (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics $130,000 $120,000 $110,000 $120,000 $100,000 1 2 3 4 5 Years (a) Constant dollars $250,000 $130,000(1+0.05)4 $120,000(1+0.05)5 $100,000(1+0.05) $120,000(1+0.05)3 $110,000(1+0.05)2 $250,000(1+0.05)0 $158,016 $138,915 $121,275 $153,154 $105,000 1 2 3 4 5 Years (b) Actual dollars $250,000 (c) 2001 Contemporary Engineering Economics

from Actual to Constant Dollars Conversion from Actual to Constant Dollars $1,260 $1,000 3 3 Actual Dollars Constant Dollars $1,260 (1 + 0.08) = $1,000 -3 (c) 2001 Contemporary Engineering Economics

Conversion from Actual to Constant Dollars End of period Cash Flow in Actual $ Conversion at f = 5% Cash Flow in Constant $ Loss in Purchasing Power -$20,000 (1+0.05)0 0% 1 20,000 (1+0.05)-1 -19,048 4.76 2 (1+0.05)-2 -18,141 9.30 3 (1+0.05)-3 -17,277 13.62 4 (1+0.05)-4 -16,454 17.73 (c) 2001 Contemporary Engineering Economics

Equivalence Calculation Under Inflation 1. Types of Interest Rate 2. Types of Cash Flow 3. Types of Analysis Method Market Interest rate (i) Inflation-free interest rate (i’) In Constant Dollars In Actual Dollars Constant Dollar Analysis Actual Dollar Analysis Deflation Method Adjusted-discount method (c) 2001 Contemporary Engineering Economics

Inflation Terminology - III Inflation-free Interest Rate (i’): an estimate of the true earning power of money when the inflation effects have been removed (also known as real interest rate). Market interest rate (i): interest rate which takes into account the combined effects of the earning value of capital and any anticipated changes in purchasing power (also known as inflation-adjusted interest rate). (c) 2001 Contemporary Engineering Economics

Inflation and Cash Flow Analysis Constant Dollar analysis - Estimate all future cash flows in constant dollars. - Use i’ as an interest rate to find equivalent worth. Actual Dollar Analysis - Estimate all future cash flows in actual dollars. - Use i as an interest rate to find equivalent worth. (c) 2001 Contemporary Engineering Economics

Constant Dollar Analysis In the absence of inflation, all economic analyses up to this point is, in fact, constant dollar analysis. Constant dollar analysis is common in the evaluation of many long-term public projects, because government do no pay income taxes. For private sector, income taxes are levied based on taxable income in actual dollars, actual dollar analysis is more common. (c) 2001 Contemporary Engineering Economics

Actual Dollars Analysis Method 1: Deflation Method - Step 1: Bring all cash flows to have common purchasing power. - Step 2: Consider the earning power. Method 2: Adjusted-discount Method - Combine Steps 1 and 2 into one step. (c) 2001 Contemporary Engineering Economics

 Step 1: Convert actual dollars to Constant dollars Cash Flows in Actual Dollars Multiplied by Deflation Factor Cash Flows in Constant Dollars -$75,000 1 -$75.000 32,000 (1+0.05)-1 30,476 2 35,700 (1+0.05)-2 32,381 3 32,800 (1+0.05)-3 28,334 4 29,000 (1+0.05)-4 23,858 5 58,000 (1+0.05)-5 45,445 (c) 2001 Contemporary Engineering Economics

Step 2: Convert Constant dollars to Equivalent Present Worth Cash Flows in Constant Dollars Multiplied by Discounting Factor Equivalent Present Worth -$75,000 1 30,476 (1+0.05)-1 27,706 2 32,381 (1+0.05)-2 26,761 3 28,334 (1+0.05)-3 21,288 4 23,858 (1+0.05)-4 16,295 5 45,445 (1+0.05)-5 28,218 $45,268 (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics Deflation Method (Example 13.6): Converting actual dollars to constant dollars and then to equivalent present worth n = 0 n = 1 n = 2 n = 3 n = 4 n = 5 Actual Dollars -$75,000 $32,000 $35,700 $32,800 $29,000 $58,000 Constant Dollars -$75,000 $30,476 $32,381 $28,334 $23,858 $45,455 Present Worth $28,218 -$75,000 $21,288 $16,295 $26,761 $27,706 $45,268 (c) 2001 Contemporary Engineering Economics

Adjusted-Discount Method Step 1 Step 2 (c) 2001 Contemporary Engineering Economics

Adjusted-Discounted Method Cash Flows in Actual Dollars Multiplied by Equivalent Present Worth -$75,000 1 32,000 (1+0.155)-1 27,706 2 35,700 (1+0.155)-2 26,761 3 32,800 (1+0.155)-3 21,288 4 29,000 (1+0.155)-4 16,296 5 58,000 (1+0.155)-5 28,217 $45,268 (c) 2001 Contemporary Engineering Economics

Adjusted-discount method $58,000 $35,700 $32,000 $32,800 $29,000 1 2 3 4 5 = $32,000 (P/F, 15.5%, 1) = $35,700 (P/F, 15.5%, 2) = $32,800 (P/F, 15.5%, 3) - $75,000 $27,706 $26,761 $21,288 $16,295 $28,218 $45,268 = $29,000 (P/F, 15.5%, 4) = $58,000 (P/F, 15.5%, 5) (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics Adjusted Discount Method: Example 13.7 Converting actual dollars to present worth dollars by applying the market interest rate n = 0 n = 1 n = 2 n = 3 n = 4 n = 5 Actual Dollars -$75,000 $32,000 $35,700 $32,800 $29,000 $58,000 Present Worth $28,218 -$75,000 $21,288 $16,295 $26,761 $27,706 $45,268 (c) 2001 Contemporary Engineering Economics

Equivalence Calculation with Composite Cash Flow Elements Approach: Convert any cash flow elements in constant dollars into actual dollars. Then use the market interest rate to find the equivalent present value. Age College expenses (in today’s dollars) (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(F/P,6%,15) = 71,897 21 (senior) 30,000(F/P,6%,16) = 76,211 (c) 2001 Contemporary Engineering Economics

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 (c) 2001 Contemporary Engineering Economics

Effects of Inflation on Project Cash Flows Item Effects of Inflation Depreciation expense Depreciation expense is charged to taxable income in dollars of declining values; taxable income is overstated, resulting in higher taxes Note: Depreciation expenses are based on historical costs and always expressed in actual dollars (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics Item Effects of Inflation Salvage value Inflated salvage value combined with book values based on historical costs results in higher taxable gains. (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics Item Effects of Inflation Loan repayments Borrowers repay historical loan amounts with dollars of decreased purchasing power, reducing the debt-financing cost. (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics Item Effects of Inflation Working capital requirement Known as working capital drain, the cost of working capital increases in an inflationary environment. (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics Item Effects of Inflation Rate of Return and NPW 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. (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics Excel Example of an after-tax cash flow analysis including differential inflation (Example 13.14) (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics $3,876 $3,000 (c) 2001 Contemporary Engineering Economics

Rate of Return Analysis under Inflation 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: n Net cash flows in actual dollars Net cash flows in constant dollars 1 2 3 4 -$30,000 13,570 15,860 13,358 13,626 12,336 13,108 10,036 9,307 IRR 31.34% 19.40% Not correct IRR (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics Summary The Consumer Price Index (CPI) is a statistical measure of change, over time, of the prices of goods and services in major expenditure groups—such as food, housing, apparel, transportation, and medical care—typically purchased by urban consumers. Inflation is the term used to describe a decline in purchasing power evidenced in an economic environment of rising prices. Deflation is the opposite: An increase in purchasing power evidenced by falling prices. (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics The general inflation rate (f) is an average inflation rate based on the CPI. An annual general inflation rate ( ) can be calculated using the following equation: Specific, individual commodities do not always reflect the general inflation rate in their price changes. We can calculate an average inflation rate for a specific commodity (j) if we have an index (that is, a record of historical costs) for that commodity. (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics Project cash flows may be stated in one of two forms Actual dollars (An): Dollars that reflect the inflation or deflation rate. Constant dollars (A’n): Year 0 dollars Interest rates for project evaluation may be stated in one of two forms: Market interest rate (i): A rate which combines the effects of interest and inflation; used with actual dollar analysis Inflation-free interest rate (i’): A rate from which the effects of inflation have been removed; this rate is used with constant dollar analysis (c) 2001 Contemporary Engineering Economics

(c) 2001 Contemporary Engineering Economics To calculate the present worth of actual dollars, we can use a two-step or a one-step process: Deflation method—two steps: 1. Convert actual dollars by deflating with the general inflation rate of 2. Calculate the PW of constant dollars by discounting at i’ Adjusted-discount method—one step 1. Compute the market interest rate. 2. Use the market interest rate directly to find the present value. (c) 2001 Contemporary Engineering Economics