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Two approaches to equivalence

calculation under inflation


1. Estimate all future cash flows in constant dollars
Use inflation-free interest rate (i) to find equivalent
worth: an estimate of the true earning power of
money when the inflation effects have been
removed (also known as real interest rate).
2. Estimate all future cash flows in actual dollars
Use market interest rate (i) to find equivalent worth:
interest rate that takes into account the combined
effects of the earning value of capital & any
anticipated changes in purchasing power (also
known as inflation-adjusted interest rate).

Constant dollar analysis


In the absence of inflation, need only to use i, to account
for the earning power of the money.
All economic analyses up to this point is, in fact, have been
constant dollar analyses.
Constant dollar analysis is common in the evaluation of
many long-term public projects, in part because
governments do no pay income taxes.
For private sector, income taxes are levied based on
taxable income in actual dollars, actual dollar analysis is
more common.

Actual dollar analysis


Two approaches to estimating equivalent present worth,
i.e. converting actual dollars into equivalent present
worth dollars:
1. Deflation method
Step 1. Bring all cash flows to have common
purchasing power.
Step 2. Consider the earning power.
2. Adjusted-discount method
Combine Steps 1 and 2 into one step.

Example 4.6, deflation method. Step 1: Convert


actual dollars to constant dollars

Cash flows in actual


dollars

Multiplied by
deflation factor

-$75,000

32,000

(1+0.05)-1

30,476

35,700

(1+0.05)-2

32,381

32,800

(1+0.05)-3

28,334

29,000

(1+0.05)-4

23,858

58,000

(1+0.05)-5

45,445

An =

An
(1 + f)n

Cash flows in
constant dollars
-$75.000

An = cash flow in constant dollars

Deflation method. Step 2: Convert constant dollars


to equivalent present worth
n

Cash flows in
constant dollars

Multiplied by
discounting factor

Equivalent
present worth

-$75,000

-$75,000

30,476

(1+0.10)-1

27,706

32,381

(1+0.10)-2

26,761

28,334

(1+0.10)-3

21,288

23,858

(1+0.10)-4

16,295

45,445

(1+0.10)-5

28,218
$45,268

Present worth of constant


dollar amount:
An
Pn =
(1 + i)n

i = inflation-free interest rate

Deflation method: Converting actual dollars to


constant dollars & then to equivalent present worth
n=0

n=1

n=2

n=3
$32,800

Actual
dollars

-$75,000

$32,000

$35,700

Constant
dollars

-$75,000

$30,476

$32,381

$28,334

$26,761

$21,288

Present
worth

-$75,000

$27,706

$45,268

n=4
$29,000

$23,858

$16,295

n=5

$58,000

$45,455

$28,218

Adjusted-discount method:
Performs deflation & discounting in one step
Step 1:

An =

An
(1 + f)n

An
Pn =
(1 + i)n

Step 2:

An
(1 + f)n
combine: Pn =
(1 + i)n
rearrange:

Pn =

An
[(1 + f)(1 + i)]n

Since market interest rate reflects both


earning power & purchasing power, it is
also true that:

An
Pn =
(1 + i)n

An
An
=
equate:
n
(1 + i)
[(1 + f)(1 + i)]n
simplify:

(1 + i) = (1 + f)(1 + i)

simplify:

1+i=

1 + i + f

+ f i

with the result that:

i = i + f + f i

Example 4.7 Adjusted-discounted method

Cash flows in actual


dollars

Multiplied
by

Equivalent
present worth

-$75,000

-$75,000

32,000

(1+0.155)-1

27,706

35,700

(1+0.155)-2

26,761

32,800

(1+0.155)-3

21,288

29,000

(1+0.155)-4

16,296

58,000

(1+0.155)-5

28,217
$45,268

i = i' + f + i' f
= 0 .1 0 + 0 . 0 5 + ( 0 .1 0 ) ( 0 . 0 5 )
= 1 5 .5 %

An
Pn =
(1 + i)n

Example 4.8. Equivalence calculation w/


composite cash flow elements: saving for college
Approach: Convert any cash flow elements in constant
dollars into actual dollars. Then use the market interest rate
to find the equivalent present value.

Age

College expenses
(in todays dollars)

College expenses
(in actual dollars)

18 (Freshman)

$30,000

$30,000(F/P,6%,13) = $63,988

19 (Sophomore)

30,000

30,000(F/P,6%,14) = 67,827

20 (Junior)

30,000

30,000(F/P,6%,15) = 71,897

21 (senior)

30,000

30,000(F/P,6%,16) = 76,211

Note: saving begins when child is age 5, 13 years before entering college

Required quarterly contributions to college funds


V1 = C(F/A, 2%, 48)
V2 = $229,211
Let V1 = V2 and solve
for C:
C = $2,888.48

Summary of ch. 4
The Consumer Price Index (CPI) is a statistical
measure of change, over time, of the prices of goods
and services in major expenditure groupssuch as
food, housing, apparel, transportation, and medical
caretypically purchased by urban consumers.
Inflation is the term used to describe a decline in
purchasing power evidenced in an economic
environment of rising prices.
Deflation is the opposite: An increase in purchasing
power evidenced by falling prices.

The general inflation rate (f) is an average inflation rate


based on the CPI. An annual general inflation rate
(f n ) can be calculated as follows:
CPI n CPI n 1
fn=
CPI n 1

Specific, individual commodities do not always reflect


the general inflation rate in their price changes. We
can calculate an average inflation rate for a specific
commodity (j) if we have an index (that is, a record of
historical costs) for that commodity.

Project cash flows may be stated in one of two forms


actual dollars (An): dollars that reflect the inflation
or deflation rate.
constant dollars (An): year 0 dollars
Interest rates for project evaluation may be stated in
one of two forms:
Market interest rate (i): a rate that combines the
effects of interest & inflation; used with actual dollar
analysis
Inflation-free interest rate (i): a rate from which the
effects of inflation have been removed; this rate is
used with constant dollar analysis

To calculate the present worth of actual dollars, we can


use a two-step or a one-step process:
Deflation method two steps:
1. Convert actual dollars by deflating with the
general inflation rate f
2. Calculate the PW of constant dollars by
discounting at i
Adjusted-discount method one step
1. Compute the market interest rate.
2. Use the market interest rate directly to find the
present value.