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Management of Highway Plant & Equipment|Views: 1,106|Likes: 19

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https://www.scribd.com/doc/53045780/Management-of-Highway-Plant-amp-Equipment

12/27/2014

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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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