DEAPARTMENT OF INTERNATIONAL ECONOMIC RELATIONS

UNIVERSITY OF ECONOMICS AND LAW

Part 2 – PROJECT APPRAISAL

Lec 5 - Inflation
Thanh-Tra Ngo, 2017

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 Contents

•  Definitions of prices & price indices

•  Inflation Adjusted Values

•  Incorporating inflation in the financial analysis

•  Consistency in inflation analysis

 Definitions of prices & price indices

•  Nominal Prices

•  Price Level and Price Index

•  Change in general price level (Inflation)

•  Real Prices

•  Changes in real prices

 Nominal prices

•  Nominal prices of goods an services are those found in

the marketplace, and often referred to as current prices.

•  Changes in nominal prices of an item is the outcome of

two sets of economic forces:

o  The forces of demand and supply for the item which

cause to changes in real prices

o  Macroeconomic forces which determine the general

price level (inflation)
 Price level & price index

•  Price level: The price level for an economy (Pt) is calculated

as weighted average of a selected set of nominal prices
Pt1 , Pt2 , Pt3........ , Ptn
n
P t = ∑ Pjt a j
Where: j

•  j denotes the individual good or service included in the

market basket.
•  Ptj denotes the price of good or service at a point in time.
•  aj denotes the weight given to the price of a particular good
or service (j); and Σ aj = 1
 Price level & price index

•  Price index = Inflation Index: Price index (It) compares the

price levels in two distinct periods. Price index simply
normalizes the price level so that in the base period, the
index is equal to 1. t
P
It = 0
P
Where :

•  Pt : price level in the period (t).

•  P0 : price level in the base period.

Changes in general price level (Inflation)

•  Change in general price level or inflation (%) is

measured by the change in the price level between two
periods divided by the price level at the beginning of the
period.
P t − P t−1 ΔP Pt
g=( t−1
)*100 = t−1 *100 = ( t−1 − 1)*100
P P P

•  Is forecasting inflation rate exactly a duty of project

analyzer?
 Comparative inflation index

•  Comparative inflation index is the ratio between

domestic inflation index ID and foreign inflation index IF

ID
IR =
IF
 Real prices

•  Real price: Real prices is calculated by nominal price

divided by the index of the price level at the same point
in time.
t
P
PiR = t
t i
I
Where:

•  PtiR : real price of good i at time t.

•  Pti : nominal price of good i in the period time (t).

•  It : price index or inflation index at time (t).

 Change in real prices
•  The change in real price of a good or service can be
expressed as :

⎛ P t
− P t −1
⎞
ΔPjR = ⎜ ⎟
t jR jR
⎜ P t −1 ⎟
⎝ jR ⎠
•  For each of the inputs and outputs, a set of projections
must be prepared in the path of its real price over the
life of the project.
•  E.g. For items where rapid technological changes
(computers, smartphones), we would expect that the
real price of those goods would fall.
 Table of price index (inflation index)
A B C D E F G H I

2 Domestic inflation 8.0%

3 Foreign inflation 3.0%

6 Year 0 1 2 3 4

Domestic inflation E7=(1+

index $C2)^E$6
7 1.00 1.08 1.17 1.26 1.36

Foreign inflation E8=(1+

index $C3)^E$6
8 1.00 1.03 1.06 1.09 1.13

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 Adjusted values to inflation

A – Cash flows

B – Nominal interest
rate

C – Nominal
exchange rate
 A – Nominal cash flows

•  Forecasting nominal prices of project’s inputs and

outputs includes 2 steps:

(i) Forecasting the changes in real prices due to

supply & demand forces

(ii) Incorporating the change in general price level

(inflation)
 Nominal cash flows

P̂
j
t+1
= P (1+ gP )(1+ gP )
j
t t
jR I
e

Where:
t+1
•  P̂j : the estimated nominal price of good j in year t+1
•  Ptj : nominal price of good j in year t
•  gPtjR : the estimated growth in real price of good j
between year t and t+1
•  gPeI : the assumed growth in price level index from
year t to year t+1
 Nominal cash flow

Year 0 1 2 3 4

Inflation rate 8%

Inflation index 1 1.08 1.17 1.26 1.36

Real cash flow -5000 1800 1900 2100 2000

Nominal cash flow =

Real cash -5000 1944 2216.2 2645.4 2721
flow*Inflation index
 B – Nominal interest rate
Nominal interest rate is made up of three major
components:
•  The real interest rate (r) which reflects the real time
value of money that lenders require in order to be willing
to forego consumption or other investment opportunities.
•  A risk factor (R) which measures the compensation
lenders demand to cover the possibility of the borrower
defaulting on the loan
•  A factor (1+r+R)gPe which represents the compensation
for the expected loss in purchasing power attributable to
inflation.
i = r + R + (1 + r + R)*gPe
 Example

i = r + R + (1 + r + R)*gPe
= r + R + gPe + (r+R)*gPe

•  r = 10%
•  R = 0%
•  g= 8%
•  i = 10% + 8% + 10%*8% = 18.8%
 C – Nominal exchange rate
The market exchange rate (EM) is the market rate of foreign
exchange between the domestic and the foreign currency,
which is expressed as the number of units of domestic
currency (#D) required to purchase one unit of foreign
exchange (F).
EM =(#D/F)t
EM = ER*(IDtn / IFtn) = ER*(1+gPDe)t/ (1+gPFe)t
Where: EM : The nominal exchange rate
ER : The real exchange rate
Idtn : The price index in year tn for the domestic currency country
IFtn : The price index in year tn for the foreign currency country
 Nominal exchange rate
A B C D E F G H I

2 Domestic inflation rate 8.0%

3 Foreign inflation rate 3.0%

4 Real exchange rate 15,000

6 Year 0 1 2 3 4
Domestic inflation E7=(1+$C2)^E
7 index $6 1.00 1.08 1.17 1.26 1.36
E8=(1+$C3)^E
8 Foreign inflation index $6 1.00 1.03 1.06 1.09 1.13
Comparative inflation
9 index E9=E7/E8 1.00 1.05 1.10 1.15 1.21

1
0 Nominal exchange rate E10=$C$4*E$9 15,000 15,728 16,492 17,292 18,132
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Incorporating inflation in the financial analysis

•  Why accounting for the impacts of inflation in

conducting the financial analysis?

•  Impacts of inflation on financial cash flows.

Why accounting for the impacts of inflation in
conducting the financial analysis

•  Assumptions regarding inflation will have a direct

impact on the financial analysis of the project and may
require adjustments in the operating or investment
policies.

•  Inflation can be a critical factor in the success or failure

of projects.
Impacts of inflation on financial cash flows
No Items NPV
Direct effects
1 Investment outlays
2 Changes in cash balance
3 Changes in account receivables
4 Changes in account payables
5 Interest payment
Indirect effects
6 Depreciation
7 Interest deduction
 Investment financing
Period 0 1 2 3
Case 1 – Inflation 0%
Price index 1.00 1.00 1.00 1.00

Investment outlays 500 500 -

-
Case 2 – Inflation 25%
Price index 1.00 1.25 1.56 1.95

Investment outlays 500 625 -

-
Impact on financing
125 -
requirements - -
 Comments

•  The presence of inflation increases the nominal amount

of the investment financing required by $125 even when
there is no increase in its material needs or costs.

•  The increased investment expense has three effects:

o  It increases the interest costs to the project if

investment costs are financed by debt.

o  It increases the nominal amount of loan principal.

o  It results in a larger nominal depreciable expense

that will be deductible for the future taxes.
 Desired cash balances
Period 0 1 2 3
Case 1 – Inflation 0%
Price index 1.00 1.00 1.00 1.00
CB 180 180
ΔCB (ending - beginning) 180 0 -180
PV(Real ΔCB) @ 8% 23.78
Case 2 – Inflation 10%
Price index 1 1.10 1.21 1.33
Nominal CB 198 217.8
Nominal ΔCB (ending –
198 19.8 -217.8
beginning)
Real ΔCB 180 16.4 -163.6
PV(Real ΔCB) @ 8% 50.80
Changes in NPV -27.02 à NPV Decrease
 Accounts Receivable (AR)
Period 0 1 2 3
Case 1 – Inflation 0%
Price index 1.00 1.00 1.00 1.00
AR 200 200
ΔAR (beginning – ending) -200 0 200
PV(ΔAR) @ 8% -26.42
Case 2 – Inflation 10%
Price index 1.00 1.10 1.21 1.33
Nominal AR 220 242
Nominal ΔAR (beginning –
-220 -22 242
ending)
Real ΔAR -200 -18.2 182
PV(Real ΔAR) @ 8% -56.44
Changes in NPV -30.02 à  NPV Decrease
 Accounts Payable (AP)
Period 0 1 2 3
Case 1 – Inflation 0%
Price index 1.00 1.00 1.00 1.00
AP 250 250
ΔAP (beginning – ending) -250 0 250
PV(ΔAP) @ 8% -33.02
Case 2 – Inflation 10%
Price index 1.00 1.10 1.21 1.33
Nominal AP 275 303
Nominal ΔAP (beginning
-275 -28 303
– ending)
Real ΔAP -250 -23.1 227.8
PV(Real ΔAP) @ 8% -70.55
Changes in NPV 37.53 à  NPV Increase
 Interest payment
Period 0 1 2 3
Real interest rate 5%

Case 1 – Inflation 0%

Nominal interest rate 5%

Disbursement 100 100

Interest expense 5.0 10.0 10.0

Principal payment 200

Project’s debt cash flow 100 95 -10 -210
PV(CF’s project debt) @
0
5%
 Interest payment (cont.)
Period 0 1 2 3
Real interest rate 5%

Case 2 – Inflation 10%

Nominal interest rate 15.5%

Price index 1.00 1.10 1.21 1.33
Nominal disbursement 100 110

Nominal interest expense 15.5 32.6 32.6

Nominal principal payment 210

Nominal project’s debt cash
100 94.5 -32.6 -242.6
flow
Real project’s debt cash flow 100 85.9 -26.9 -182.2
PV(Real CF’s project debt) @
0
5%
 Comparison of real cash flow

Period 0 1 2 3

5% interest with 0% inflation (1) 100.0 95.0 -10.0 -210.0

15.5% interest with 10% inflation (2) 100.0 85.9 -26.9 -182.2

Difference in real cash flow

0.0 -9.1 -16.9 27.8
[(2) – (1)]
 Depreciation
Period 0 1 2 3
Income tax rate 25%
Depreciable investment 900
Case 1 – Inflation 0%
Depreciation 300 300 300
Tax savings 75.0 75.0 75.0
PV(Tax savings) @ 8% 193.3
Case 2 – Inflation 10%
Price index 1.00 1.10 1.21 1.33
Nominal depreciation 300 300 300
Nominal tax savings 75.0 75.0 75.0
Real tax savings 68.2 62.0 56.3
PV(Real tax savings) @ 8% 161,0
Changes in NPV -32,3 à  NPV Decrease
 Interest deduction
Period 0 1 2 3
Income tax rate 25% Real interest rate 5%
Case 1 – Inflation 0% Nominal interest rate 5%
Disbursement 100 100
Interest expense 5.0 10.0 10.0
Tax savings 1.25 2.50 2.50
PV(Tax savings) @ 8% 5,3
Case 2 – Inflation 10% Nominal interest rate 15.5%
Price index 1.00 1.10 1.21 1.33
Nominal disbursement 100 110
Nominal interest expense 15.5 32.6 32.6
Nominal tax savings 3.88 8.14 8.14
Real tax savings 3.52 6.73 6.11
PV(Real tax savings) @ 8% 13.9
Changes in NPV 8.6 à  NPV Increase
Impacts of inflation on financial cash flows
No Items NPV
Direct effects
1 Investment outlays ?
2 Changes in cash balance Decrease
3 Changes in account receivables Decrease
4 Changes in account payables Increase
5 Interest payment 0
Indirect effects
6 Depreciation Decrease
7 Interest deduction Increase
 Consistency in inflation analysis
(Inflation rate = 8%)
Year 0 1 2 3 4
Domestic price index 1 1.08 1.17 1.26 1.36
Real cash flow -5000 1800 1900 2100 2000
Nominal cash flow -5000 1944 2216 2645 2721

Nominal NPV is calculated by Real NPV is calculated by

discounting nominal cash flow discounting real cash flow
with nominal discount rate with real discount rate
 Consistency in inflation analysis

Year (Inflation rate = 8%) 0 1 2 3 4

Inflation index 1 1.08 1.17 1.26 1.36

Real cash flow -5000 1800 1900 2100 2000

Nominal cash flow -5000 1944 2216.2 2645.4 2721

Real discount rate 10%

Nominal discount rate 18.8%

Real NPV 1150

Nominal NPV 1150

 Consistency in inflation analysis

•  Nominal NPV is normally equal to real NPV in most of

cases. However, nominal NPV can be little bit different
from real NPV in case of presence of working capital
in project.

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