L12: Actual and Constant Dollars ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

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).

Conversion from Constant to Actual Dollars $1,000 ( ) = $1,260 3 Constant Dollars $1,000 3 Actual Dollars $1,260 3

Example 4.3 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

$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

Conversion from Actual to Constant Dollars Constant Dollars $1,260 ( ) = $1, $1,000 3 Actual Dollars $1,260 3

Example 4.4 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) ,

Practice Problem - How to Compare the Winning Prizes in Two Different Points in Time Jack Nicklaus won his first Master Tournament in The prize was $20,000. Phil Mickelson won his first Master Tournament in The prize amount was $1.17M

Consumer Price Index Average inflation rate = 4.525%

What is the worth of $1.17M in terms of purchasing power in 1963? The average inflation rate between 1963 and 2004 is about 4.53% per year. $1.17M in 2004 would have a purchasing power of $190,616 in 1963

If Jack invested his prize money in 1963 at 5.65% (inflation-free interest rate), the prize money would grow to match Phil’s 2004 prize $20,000 $190,