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Management of Highway Plant & Equipment

Management of Highway Plant & Equipment

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Year Proposal 1

Cash flow (£)

Present worth factors

Present worth (£)

0

8,500

1

8,500.00

1

1,750

0.95652

1,673.90

2

1,750

0.91493

1,601.13

3

1,750

0.87515

1,531.51

4

1,750

0.83710

1,464.93

5

1,750

0.80070

1,401.22

Total present worth

16,172.69

Another example would be to assume an interest rate of 15 per cent and an inflation rate
of 15 per cent. Since the inflation rate and the rate at which interest is earned are the
same, the effective rate becomes zero, as follows:

Thus, if £100 at present day prices were due at the end of one year and inflation at 15 per
cent made this £115, the amount required to be invested today at 15 per cent to produce
£115 in one year would be £115×0.86956=£100 (0.86956 is the present worth factor for
15 per cent). If the £100 required at the end of one year were left and the effect of
inflation taken away from the interest rate, then the amount required today at zero per
cent would be £100×1.0=£100, where 1.0 is the present worth factor for zero per cent.
The amount required by both calculations is the same.
This example is particularly noteworthy because, if inflation rates and interest rates are
equal, calculating present worths taking account of inflation simply involves summing
the cash flows estimated at present prices. The effect of inflation totally eliminates the
earned interest.

A final example would be to assume an interest rate of 15 per cent, as before, but an
inflation rate of 20 per cent so that the inflation rate is greater than the rate at which
interest can be earned. The effective rate then becomes −4.16 per cent as follows:

Thus, if £100 at present-day prices were due at the end of one year and inflation at 20 per
cent would make this £120, the amount required to be invested today at 15 per cent to

Management of off-highway plant and equipment 72

produce £120 in one year would be £120×0.86956=£104.34, where 0.86956 is the present
worth factor for 15 per cent. If the £100 required at the end of one year were left and the
effect of inflation taken away from the interest rate, then the amount required today at
−4.16 per cent would be £100×1/(1−0.0416)1

=£100×1.0434=£104.34, where 1.0434 is
the present worth factor for −4.16 per cent. It is to be noted that the present worth factor
had to be calculated from the expression 1/(1+i)n

because negative interest rates are not
usually tabulated. Again the amounts required calculated by the two methods are the
same.

Thus, this method of adjusting the interest rate is valid for all interest and inflation
rates and, by producing cash flows estimated on the basis of present-day prices, the effect
of inflation at various rates can be easily assessed, using a range of assumed inflation
rates. The following example illustrates the application of this technique to Example 5.2.

Example 5.7

Year Cash flow for the purchase, operating and resale of an item of equipment (£)

0

−8,500

1

−1,750

2

−1,850

3

−2,000

4

−2,200

5

−2,500 + 4,000

Table 5.9 Proposal 1 present worth allowing for
12% inflation for Example 5.7

Year Cash flow (£)

Present worth factors

Present worth (£)

0

−8,500

1.0

−8,500.00

1

−1,750

0.9739

−1,704.32

2

−1,850

0.9485

−1,754.73

3

−2,000

0.9237

−1,847.40

4

−2,200

0.8996

−1,979.12

5

−2,500

0.8761

−2,190.25

5

+4,000

0.8761

+3,504.40

Total present worth

–14,471.42

The cash flows estimated at present-day prices reflect only the increasing cost of
operating the equipment and not increases due to inflation.

Economic comparisons of equipment alternatives 73

The value of money is 15 per cent. The present worth, as shown in Example 5.2, is
£13,247.72. If inflation over the next five years is estimated at 12 per cent, the effective
interest rate would be 2.68 per cent, calculated as follows

The present worth of the cash flows, allowing for inflation at 12 per cent, is £14,471.42,
calculated as presented in Table 5.9. This £14,471.42 is the present worth of the original
cash flows plus the present worth of the additional cash flows that would have to be
included for inflation.

Method 4: varying inflation rates

Methods 2 and 3 illustrate how uniform inflation rates can be dealt with, but this leaves
the difficulty of coping with varying inflation rates. The most commonly adopted
approach in these economic comparisons is to take a long-term view of the interest rate to
be used to represent the value of money and to ignore short-term variations.
The same argument is usually applied to the assumed inflation rates. It is possible, if
required, to cope with varying inflation rates but to do this by adjusting the cash flows as
illustrated in Method 3 for uniform inflation rates. The following example based on
Example 5.5 demonstrates how cash flows can be adjusted for varying inflation rates.
The assumed inflation rates are 10 per cent for years one and two, 12 per cent for year
three and 14 per cent for years four and five.

Example 5.8

Proposal 1

Table 5.10 shows the cash flow adjustments for Proposal 1. When calculated, these
figures become:

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