Engineering Economics in Canada Chapter 9 Inflation

Copyright © 2006 Pearson Education Canada Inc. 9-2 Inflation: An increase in the average price paid for goods and services over time. – Results in a reduction in purchasing power. Deflation: A decrease in the average price paid for goods in services over time. –Results in an increase in purchasing power. Different ideas: time value of money, interests, tax. Review

Copyright © 2006 Pearson Education Canada Inc. 9-3 If we expect inflation, the actual dollars returned by a project does not reflect the actual purchasing power of the future cash flow. The purchasing power depends on the real dollar value of the earnings Review Effect of Inflation on the MARR

Copyright © 2006 Pearson Education Canada Inc. 9-4 The actual value of $M invested for one year at an actual interest rate i: M (1 + i) If the inflation rate over the next year is f, the real value of our cash flow is: M(1+i)/(1+f) Effect of Inflation on the MARR…

Copyright © 2006 Pearson Education Canada Inc. 9-5 The real interest rate, i’, is the interest rate that would yield the same number of real dollars in the absence of inflation as the actual interest rate yields in the presence of inflation: Real Interest Rate

Copyright © 2006 Pearson Education Canada Inc. 9-6 The Effect of Inflation on the IRR (Not Required for Quiz) The effect of expected inflation on the actual IRR of a project is similar to the effect of inflation on the actual MARR. Say we have a project with a first cost A 0 and actual cash flows A 1, A 2, …, A T The actual IRR can be found by solving for i in:

Copyright © 2006 Pearson Education Canada Inc. 9-7 Actual IRR (Not Required for Quiz) An annual inflation rate f is expected over the T year life of the project. In terms of real dollars (base year = now), the stream of actual cash flows can be written as (note: R 0 =A 0 ) The expression which gives the actual IRR can be rewritten as:

Copyright © 2006 Pearson Education Canada Inc. 9-8 Real IRR (Not Required for Quiz) The real IRR is the rate of return obtained on the real dollar cash flows associated with the project. It is the solution for i’ in: What is the relationship between the real IRR and the actual IRR?

Copyright © 2006 Pearson Education Canada Inc. 9-9 The engineer typically has been given an observed, or actual, MARR As we have seen, the actual MARR consists of two parts: –the real MARR and –an adjustment for anticipated inflation The projected cash flows are often stated in real (current) dollars, i.e., they do not include adjustments for inflation The challenge is to recognize that we have an actual MARR, but real cash flows 9.5 Project Evaluation Methods With Inflation

Copyright © 2006 Pearson Education Canada Inc There are two correct ways to proceed: Method 1: Work with real cash flows and find the real MARR using an estimate of f Method 2: Adjust the real cash flows for inflation, i.e., get estimates of the actual cash flows using f, and apply the actual MARR Project Evaluation Methods with Inflation…

Copyright © 2006 Pearson Education Canada Inc Sources of forecasts of f over the short term (<1 year) can be found in publications such as The Globe and Mail and Report on Business Longer term projects need longer term forecasts of inflation if some actual cash flows are fixed by contract Longer term forecasts will be estimates, with all the uncertainty of extrapolations, and hence it is wise to evaluate the project(s) over a range of possible inflation rates Project Evaluation Methods with Inflation…

Copyright © 2006 Pearson Education Canada Inc A computer has a first cost of $3000 and is expected to bring about actual savings of $1700 in year 1 and $1800 in year 2. Expected actual salvage value at the end of 2 years is $500. Inflation is 5% per year and the real MARR is 12%. Based on an IRR analysis, should the project be undertaken? Example 9-4

Copyright © 2006 Pearson Education Canada Inc Three approaches are possible: 1.Convert the actual cash flows into real cash flows and find the real IRR directly. Compare to the real MARR. 2.Use the actual cash flows to determine an actual IRR, convert to a real IRR and compare to the real MARR. 3.Use the actual cash flows to determine an actual IRR, convert the real MARR to an actual MARR. Example 9-4: Answer

Copyright © 2006 Pearson Education Canada Inc Method 1: The actual cash flows are: –3000, 1700, 2300 (= ) The real cash flows are: Now, to get the real IRR, solve for i in: The real IRR is 14.65%. Example 9-4: Answer

Copyright © 2006 Pearson Education Canada Inc Method 2: Solve for the value of i such that: which gives an actual IRR of 20.36%. Converting to a real IRR we get which (with a small rounding error) is the same as we obtained working with real cash flows. Example 9-4: Answer

Copyright © 2006 Pearson Education Canada Inc Method 3: use actual IRR and calculate actual MARR: All methods indicate that the IRR exceeds the MARR  we should proceed with the project. Example 9-4: Answer

Copyright © 2006 Pearson Education Canada Inc Summary Inflation and deflation defined Measuring the inflation rate Economic Evaluation with Inflation –Converting between real and actual dollars The Effect of Correctly Anticipated Inflation –The effect of inflation on the MARR –The effect of inflation on the IRR Project evaluation Methods with Inflation Blue: calculation not required

Copyright © 2006 Pearson Education Canada Inc Quiz 3---When and Where Quiz: Tuesday, Oct. 25, : :20 (Quiz: 30 minutes) Tutorial: Wednesday, Oct. 26, 2005 ELL 168 Group 1 (Students with Last Name A-M) ELL 061 Group 2 (Students with Last Name N-Z)

Copyright © 2006 Pearson Education Canada Inc Quiz---Who will be there CraigTipping Group 1 (Last Name A-M) ELL 168 LeYang Group 2 (Last Name N-Z) ELL 061 If you cannot make it, me before the quiz, not your TA!!! If you have emergency, or talk to your TA and me as early as possible. So far still there are students skipped Quiz 2 and did not contact me: “0” already.

Copyright © 2006 Pearson Education Canada Inc Quiz----Recourse Visit my Homepage Please, you have my phone, , Address, all slides, quiz times. Make sure you are here is your job, NOT: Wei, BC ferry, Air Canada, Apollo 13, Sky Train, etc. Marks: and Talk to your TA if really needed, (find the correct one please) if no good, then you want to talk to me 1 mark is not that important

Copyright © 2006 Pearson Education Canada Inc Quiz---Problems, Solutions All problems on sheet this time Solutions will be given on Tutorial Bring: Blank Letter Paper, Pen, Formula Sheet, Calculator, Student Card Write: Name, Student No. and (Please……)

Copyright © 2006 Pearson Education Canada Inc Quiz---Based on Chapter Important: Wei’s Slides Even More Important: Examples in Slides (slides after 22 in class 17 not required for calculation) 1 Formula Sheet is a good idea 3 Questions for 1800 seconds. Wei used 907 seconds Today’s content/slides not required

Copyright © 2006 Pearson Education Canada Inc Project----Time Table Find your group: Mid-October Select Topic: End of October Survey finished: End of October Project: November (3 Weeks) Project Report Due: Final Quiz

Copyright © 2006 Pearson Education Canada Inc Project----Requirements Group: 3-6 Students (sound be done now) Topic: Practical, (means real data, reasonable topic), could me for suggestion Report Length: 15 pages-30 printed pages. Report: On Time, Original Marks: 1 mark to 1 report, one group No spoon feed: Independent Team work Report: 25 marks out of 100

Copyright © 2006 Pearson Education Canada Inc Project Topic----What to do You Find the topic Example: A Survey on effect of inflation on high education in Canada (or third world country, USA, etc.) Example: Government approaches on economic adjustments and their effect. Example: Public Service and Inflation Hope: several papers will be published.

Copyright © 2006 Pearson Education Canada Inc Project----Recourse Not your teaching group Example: Government Web Example: Library, Database, Google Example: Economics Faculty Example: Newspaper, TV Example: Friends