(c) 2001 Contemporary Engineering Economics 1 Chapter 13 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 2 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 3 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 4 Purchasing Power 1990 $ $100 You could buy 50 Big Macs in year You can only buy 40 Big Macs in year $2.00 / unit $2.50 / unit 25% Price change due to inflation The $100 in year 2001 has only $80 worth purchasing power of 1990

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

(c) 2001 Contemporary Engineering Economics 6 Price Increase Due to Inflation Item1967 Price2000 Price% Increase Consumer price index (CPI) Monthly housing expense$114.31$ Monthly automobile expense Loaf of bread Pound of hamburger Pound of coffee Candy bar Men’s dress shirt Postage (first-class) Annual public college tuition , ,247

(c) 2001 Contemporary Engineering Economics 7 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 8 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 9 Selected Price Indexes Year Base Period New CPI Old CPI 1967 Gasoline 1982 Steel 1982 Passenger Car

(c) 2001 Contemporary Engineering Economics 10 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 ( ) ( ) = $ Step 2: Find the average inflation rate by solving the following equivalence equation. $100 ( 1+ f) = $ f = 5.98% 2 $100 $

(c) 2001 Contemporary Engineering Economics 11 Average Inflation Rate Item 1967 Price2000 PriceAverage Inflation Rate Consumer price index (CPI) % Monthly housing expense $114.31$ Monthly automobile expense Loaf of bread Pound of hamburger Pound of coffee Candy bar Men’s dress shirt Postage (first-class) Annual public college tuition ,

(c) 2001 Contemporary Engineering Economics 12 General Inflation Rate (f) Average inflation rate based on the CPI

(c) 2001 Contemporary Engineering Economics 13 Example 13.2: Yearly and Average Inflation Rates YearCost 0$504, , , ,500 What are the annual inflation rates and the average inflation rate over 3 years? Solution Inflation rate during year 1 (f 1 ): ($538,400 - $504,000) / $504,000 = 6.83%. Inflation rate during year 2 (f 2 ): ($577,000 - $538,400) / $538,400 = 7.17 %. Inflation rate during year 3 (f 3 ): ($629,500 - $577,000) / $577,000 = 9.10%. The average inflation rate over 3 years is

(c) 2001 Contemporary Engineering Economics 14 Inflation Terminology – II Actual Dollars (A n ): 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 (A n ’ ): 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 15 Conversion from Constant to Actual Dollars $1,000 ( ) = $1,260 3 Constant Dollars $1,000 3 Actual Dollars $1,260 3

(c) 2001 Contemporary Engineering Economics 16 Conversion from Constant to Actual Dollars PeriodNet Cash Flow in Constant $ Conversion Factor Cash Flow in Actual $ 0-$250,000(1+0.05) 0 -$250, ,000(1+0.05) 1 105, ,000(1+0.05) 2 121, ,000(1+0.05) 3 138, ,000(1+0.05) 4 158, ,000(1+0.05) 5 153,154

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

(c) 2001 Contemporary Engineering Economics 18 Conversion from Actual to Constant Dollars Constant Dollars $1,260 ( ) = $1, $1,000 3 Actual Dollars $1,260 3

(c) 2001 Contemporary Engineering Economics 19 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 0-$20,000(1+0.05) 0 -$20,0000% 120,000(1+0.05) , ,000(1+0.05) , ,000(1+0.05) , ,000(1+0.05) ,

(c) 2001 Contemporary Engineering Economics 20 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 21 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 22 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 23 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 24 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 25 Step 1: Convert actual dollars to Constant dollars nCash Flows in Actual Dollars Multiplied by Deflation Factor Cash Flows in Constant Dollars 0-$75,0001-$ ,000(1+0.05) -1 30, ,700(1+0.05) -2 32, ,800(1+0.05) -3 28, ,000(1+0.05) -4 23, ,000(1+0.05) -5 45,445

(c) 2001 Contemporary Engineering Economics 26 Step 2: Convert Constant dollars to Equivalent Present Worth nCash Flows in Constant Dollars Multiplied by Discounting Factor Equivalent Present Worth 0-$75, ,476(1+0.05) -1 27, ,381(1+0.05) -2 26, ,334(1+0.05) -3 21, ,858(1+0.05) -4 16, ,445(1+0.05) -5 28,218 $45,268

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

(c) 2001 Contemporary Engineering Economics 28 Adjusted-Discount Method Step 1 Step 2

(c) 2001 Contemporary Engineering Economics 29 Adjusted-Discounted Method nCash Flows in Actual Dollars Multiplied by Equivalent Present Worth 0-$75, ,000( ) -1 27, ,700( ) -2 26, ,800( ) -3 21, ,000( ) -4 16, ,000( ) -5 28,217 $45,268

(c) 2001 Contemporary Engineering Economics 30 Adjusted-discount method $75,000 $27,706 $26,761 $21,288 $16,295 $28,218 $45,268 = $32,000 (P/F, 15.5%, 1) = $35,700 (P/F, 15.5%, 2) = $32,800 (P/F, 15.5%, 3) = $29,000 (P/F, 15.5%, 4) = $58,000 (P/F, 15.5%, 5) $32,000 $35,700 $32,800 $29,000 $58,000

(c) 2001 Contemporary Engineering Economics 31 Adjusted Discount Method: Example 13.7 Converting actual dollars to present worth dollars by applying the market interest rate n = 0 n = 1n = 2n = 3n = 4n = 5 -$75,000 $32,000 $35,700 $32,800 $29,000 $58,000 Actual Dollars -$75,000 $27,706 $26,761 $21,288 $16,295 $28,218 $45,268 Present Worth

(c) 2001 Contemporary Engineering Economics 32 Equivalence Calculation with Composite Cash Flow Elements AgeCollege expenses (in today’s dollars) College expenses (in actual dollars) 18 (Freshman)$30,000$30,000(F/P,6%,13) = $63, (Sophomore)30,00030,000(F/P,6%,14) = 67, (Junior)30,00030,000(F/P,6%,15) = 71, (senior)30,00030,000(F/P,6%,16) = 76,211 Approach: Convert any cash flow elements in constant dollars into actual dollars. Then use the market interest rate to find the equivalent present value.

(c) 2001 Contemporary Engineering Economics 33 V 1 = C(F/A, 2%, 48) V 2 = $229,211 Let V 1 = V 2 and solve for C: C = $2, Required Quarterly Contributions to College Funds

(c) 2001 Contemporary Engineering Economics 34 Effects of Inflation on Project Cash Flows ItemEffects 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 35 ItemEffects of Inflation Salvage valueInflated salvage value combined with book values based on historical costs results in higher taxable gains.

(c) 2001 Contemporary Engineering Economics 36 ItemEffects of Inflation Loan repaymentsBorrowers repay historical loan amounts with dollars of decreased purchasing power, reducing the debt-financing cost.

(c) 2001 Contemporary Engineering Economics 37 ItemEffects 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 38 ItemEffects 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 39 Excel Example of an after-tax cash flow analysis including differential inflation (Example 13.14)

(c) 2001 Contemporary Engineering Economics 40 $3,876 $3,000

(c) 2001 Contemporary Engineering Economics 41 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 $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

(c) 2001 Contemporary Engineering Economics 42 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 43 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 44 Project cash flows may be stated in one of two forms Actual dollars (A n ): 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 45 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.