1. Chapter 14: Inflation and Price Change Engineering Economic Analysis Canadian Edition

2. 14-2 Chapter 14 … nDescribes inflation, explains how it occurs, and lists its effects on purchasing power. nDefines $ values and interest rates as either real or nominal. nDemonstrates how to analyze cash flows either in real dollars or in nominal dollars, using constant or varying inflation rates, and with before-tax or after-tax amounts. nIntroduces price indexes.

3. 14-3 Meaning and Effect of Inflation nInflation makes future dollars less valuable than present dollars. A sandwich that cost $3.00 last year and $3.06 this year is an example of individual item inflation of 2% per year. If the average price of a loaf of bread moves from $2.90 last year to $2.99 this year, the commodity ‘bread’ has inflated 3.1% per year. If a market basket of goods used by the average individual costs $128.77 this year versus $125.75 last year, general consumer prices have risen by 2.4% per year.

4. 14-4 Deflation is negative inflation, when goods cost less in the future. Deflation is rare. Effect of Inflation nInflation causes the value of money to be reduced in the future. nInflation tends to cause goods and services to cost more and time increases. nInflation is pervasive. Many industrialized countries like to see inflation contained between about 1% and 3% per year.

5. 14-5 How Does Inflation Happen? nMoney supply increases: money available to consumers in the general economy increases faster than the goods available. nExchange rates: prices change to reflect the comparative value of currencies in different countries. nCost-push inflation: producers raise prices to cover costs. nDemand-pull inflation: consumers bid up prices by attempting to buy more than is available.

6. 14-6 Interest Rate Definitions nInflation rate (f): rate of change of the cost of an item, commodity, or market basket of goods. nReal interest rate (i’): ‘real’ interest earned on an investment — the inflation-free interest rate. nNominal interest rate (i): the interest paid for borrowing money in the open market, the combined interest rate. The nominal interest rate also includes a margin for the lender’s risk.

7. 14-7 Calculation of Inflation (1+i) = (1+i’)(1+f) i = i’ + f + (i’)(f)

8. 14-8 Nominal & Real Dollars Definitions nNominal dollars: cash money — the kind you carry in your pocket; include the effects of inflation. nReal dollars: dollars with constant purchasing power, expressed using a base year; e.g.1992-based dollars. These are inflation-free (fictitious) dollars.

9. 14-9 Inflation Examples nYour father says his monthly salary was $1075 in 1972. You expect your monthly salary will be $4950 when you graduate in 2008. If inflation has averaged 4.35% per year between 1972 and 2008, whose salary is higher (in real value)? nYour father invested $10,000 in 1972 in deposit bonds that give an annual rate of return of 5.65%. Calculate the maturity value in 2008 and find the real rate of return, using the same rate of inflation as above.

10. 14-10 Nominal and Real Dollars Analysis nAnalysis must be consistent: either real $ with real interest rates, or vice versa. Results are usually the same with no taxes. After tax results are different because some cash flows (e.g. depreciation and interest) do not inflate.

11. 14-11 nIndexes track and describe relative price changes over time. nIndexes can be for a specific commodity or composite for a bundle of commodities. nStatistics Canada tracks price levels and publishes the Consumer Price Index (CPI) for Canada and for each province. See http://www.statcan.ca/english/Subjects/Cpi/cp i-en.htm) and the charts on the next page. http://www.statcan.ca/english/Subjects/Cpi/cp i-en.htm Price Changes with Indexes

12. 14-12 Price Changes with Indexes … nCPI as reported June 19, 2007. Source: Statistics Canada.

13. 14-13 Price Changes with Indexes … nThe base value for the CPI is 100 and the base year is 2002. nThe CPI as of May, 2007, was 112.1. A market basket of goods and services that cost $100 in 2002 had a cost of $112.10 in May/07. nThe annual rate of inflation as of May, 2007, was 2.188%. The price level of a market basket of goods and services has increased by 2.188% from May/06 to May/07.

14. 14-14 Inflation Issues nDifferent cash flows inflate at different rates. Example: Your firm is considering an investment that requires an initial outlay of $350K. The expected annual revenue is $250K and the annual cost is $165K; both amounts are in today’s dollars. During the ten-year life of the investment, it is expected that the revenue will grow at 2% per year and the cost at 3% per year. Determine if your firm should accept this investment if it uses a nominal MARR of 12%. The marginal tax rate is 37% and your firm uses straight-line depreciation. nIn such cases, use nominal analysis (nominal cash flows with nominal rates of interest).

15. 14-15 Inflation Issues … nThe inflation rate changes during the analysis period of a project. nApply the inflation rate on a year-by-year basis and then find the measure of merit. A six-year investment requires an initial outlay of $850K. Annual net earnings are $240K before tax. For the first three years, the annual inflation rate will be 2%; for the second three years, it will be 4%. The nominal MARR is 14%. The CCA rate is 30% and the marginal tax rate is 38%. All amounts are in today’s dollars. Should the invest- ment be accepted if the salvage value is $120K?

16. 14-16 Suggested Problems n14-12, 20, 26, 28, 35, 42, 49, 55.