1. www.izmirekonomi.edu.tr L12: Actual and Constant Dollars ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

2. www.izmirekonomi.edu.tr 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).

3. www.izmirekonomi.edu.tr Conversion from Constant to Actual Dollars $1,000 (1 + 0.08) = $1,260 3 Constant Dollars $1,000 3 Actual Dollars $1,260 3

4. www.izmirekonomi.edu.tr 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 1100,000(1+0.05) 1 105,000 2110,000(1+0.05) 2 121,275 3120,000(1+0.05) 3 138,915 4130,000(1+0.05) 4 158,016 5120,000(1+0.05) 5 153,154

5. www.izmirekonomi.edu.tr 0 12345 0 12345 $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

6. www.izmirekonomi.edu.tr Conversion from Actual to Constant Dollars Constant Dollars $1,260 (1 + 0.08) = $1,000 -3 $1,000 3 Actual Dollars $1,260 3

7. www.izmirekonomi.edu.tr 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) -1 -19,0484.76 220,000(1+0.05) -2 -18,1419.30 320,000(1+0.05) -3 -17,27713.62 420,000(1+0.05) -4 -16,45417.73

8. www.izmirekonomi.edu.tr Practice Problem - How to Compare the Winning Prizes in Two Different Points in Time Jack Nicklaus won his first Master Tournament in 1963. The prize was $20,000. Phil Mickelson won his first Master Tournament in 2004. The prize amount was $1.17M. 19632004

9. www.izmirekonomi.edu.tr Consumer Price Index 1963 91.7 2004 561.23 1967 100 Average inflation rate = 4.525%

10. www.izmirekonomi.edu.tr 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

11. www.izmirekonomi.edu.tr 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. 0 1963 41 2004 $20,000 $190,616 1963 0