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Dr. Karim

Chapter 4:

Inflation and Its Impact on Project

What is inflation?

How do we incorporate the effect of inflation

in economic analysis?

3

What is Inflation?

Value of Money

Earning Power

Purchasing power

Earning Power

Investment Opportunity

Purchasing Power

inflation)

Increase in purchasing Power (deflation)

Purchasing Power

$100

$100

1990

1990

in year 1990.

$2.00 / unit

25%

Price change

due to

2001

Macs in year 2001.

$2.50 / unit

inflation

The $100 in year 2001 has only $80

value purchasing power of 1990

5

$100

-2

-1

$100

0

-2

80 liters of unleaded gas.

63.69 liters of unleaded

gasoline a year ago.

$1.57 / gallon

-1

20.38%

$1.25 / gallon

deflation

Measuring Inflation

Consumer Price Index (CPI): the CPI

compares the cost of a sample market basket of

goods and services in a specific period relative to

the cost of the same market basket in an earlier

reference period. This reference period is designated

as the base period or base year.

Market basket

Base Period (1967)

2001

$100

$512.9

CPI for 2001 = 512.9

7

(The annual percentage change in a CPI is used to measure inflation)

Item

1967 Price

2000 Price

% Increase

(Base Year)

512.9

$114.31

$943.97

726 %

82.69

471.38

470 %

Loaf of bread

.22

1.84

736 %

Pound of hamburger

.39

2.98

564 %

Pound of coffee

.59

4.10

595 %

Candy bar

.10

0.90

5.00

39.00

680 %

Postage (first-class)

0.05

0.33

660 %

294.00

3,960.00

1,247 %

100

Monthly automobile expense

Specific, individual commodities do not always reflect

the general inflation rate in their price changes. We

can calculate an average inflation rate (f ) for a

specific commodity (j) if we have an index (that is, a

record of historical costs) for that commodity.

Fact:

Base Price = $100 (year 0)

Inflation rate (year 1) = 4%

Inflation rate (year 2) = 8%

Average inflation rate over 2 years?

$100 ( 1 + 0.04) ( 1 + 0.08) = $112.32

following equivalence equation.

2

$100 ( 1+ f) = $112.32

f = 5.98%

$112.32

1

2

$100

11

Item

Consumer price index (CPI)

Monthly housing expense

Monthly automobile expense

1967 Price

100

2000 Price

Average Inflation

Rate

512.9

5.07%

$114.31 $943.97

6.61

82.69

471.38

5.42

Loaf of bread

0.22

1.84

6.64

Pound of hamburger

0.39

2.98

6.36

Pound of coffee

0.59

4.10

6.05

Candy bar

0.10

0.90

6.88

5.00

39.00

6.42

Postage (first-class)

0.05

0.33

5.89

294.00 3,960.00

8.19

12

Year

Cost

$504,000

538,000

577,000

629,500

and the average inflation rate (f ) over 3 years?

Solution

[($538,400 - $504,000) / $504,000]* 100 = 6.83%.

Inflation rate during year 2 (f2):

[($577,000 - $538,400) / $538,400] * 100 = 7.17 %.

Inflation rate during year 3 (f3):

[($629,500 - $577,000) / $577,000] * 100 = 9.10%.

The average inflation rate over 3 years is

$504,000 ( 1+ f)3 = $629,500

f = 7.69 %

13

Inflation Terminology - II

With inflation all dollars are not the same.

When inflation is considered in an economic analysis, money

is expressed by two measures: real and actual dollars.

We will see that either measure can be used for an analysis,

but it is important to understand the distinction between the

two.

1- Actual / Current Dollars (An ): Estimates of future cash

flows for year n that take into account any anticipated

changes in amount caused by inflationary or deflationary

effects.

flows for year n in constant purchasing power, independent

of the passage of time (base year dollars).

If we have a cash flow expressed in real dollars (base

year dollars), it is expressed in actual dollars by

inflating the amounts individually for each period.

we use the general inflation rate (f) as an inflation

factor.

_

An A' n (1 f ) A' n ( F / P, f , n)

$1,000

n3

$1,260

f 8%

3

Constant

Dollars

3

$1,000 (1 + 0.08)

= $1,260

Actual

Dollars

Period

Constant $

Conversion

Factor

Cash Flow in

Actual $

-$250,000

(1+0.05)0

-$250,000

100,000

(1+0.05)1

105,000

110,000

(1+0.05)2

121,275

120,000

(1+0.05)3

138,915

130,000

(1+0.05)4

158,016

120,000

(1+0.05)5

153,154

19

$100,000

$110,000

$120,000 $130,000

$120,000

$105,000

$121,275

$120,000(1+0.05)3

Years

(a) Constant dollars

5

$120,000(1+0.05)5

$130,000(1+0.05)4

$110,000(1+0.05)2

$250,000(1+0.05)0

$250,00

0

$100,000(1+0.05)

$138,915 $158,016

$153,154

0

1

$250,000

Years

(b) Actual dollars

20

Applied Example

A 25 year old college graduate has just been hired for her first job. She brags that she

will save enough money to retire at 55 with one million dollars. But wait. Lets

assume a 3% annual inflation rate over her 30 year career. If she wants her

retirement fund to have the value of one million of todays dollars, how much must

she save?

When the college student is planning for her retirement, she is probably thinking of the

1 million dollars in terms of todays dollars. If she could retire today, she thinks she

can live happily with 1 million dollars. But after 30 years, that amount will not buy

what it can today

todays real dollars?

Solution

The $1 million is in real dollars. Changing it to actual dollars

we find that she will have to save almost $2.5 million. She

will start spending her retirement money in 30 years. Money

spent is always measured in actual dollars. The actual dollar

equivalent assuming 3% inflation is almost $2.5 million

dollars = 1000000 (1+0.03)30 = 2427262.47$

Wouldnt she be disappointed if she only saved 1 million

??

Our illustration is the same as the one used earlier except now

we start with the actual dollars. The amounts in each year

are deflated by the general inflation rate We use the

general inflation rate (f) as measured by the CPI in the

discount factor.

Of course, we obtain the uniform series that we started with.

We should note from our examples that the amount at time 0

did not change. Amounts at time 0 are the same in real or

actual dollars because there is no passage of time.

_

A' n An (1 f ) An ( P / F, f , n)

$1,000

n3

$1,260

f 8%

3

Constant

Dollars

-3

$1,260 (1 + 0.08)

= $1,000

Actual

Dollars

End of

period

Cash Flow

in Actual $

Loss in

at f = 5%

Constant $ Purchasing

Power

-$20,000

(1+0.05)0

-$20,000

0%

20,000

(1+0.05)-1

-19,048

4.76

20,000

(1+0.05)-2

-18,141

9.30

20,000

(1+0.05)-3

-17,277

13.62

20,000

(1+0.05)-4

-16,454

17.73

25

1.

2.

Market Interest Rate (i)

Real Interest Rate (i)

In Actual / Current Dollars

3.

Constant Dollar Analysis

Actual Dollar Analysis

Deflation Method

Adjusted-discount method

26

Interest rates for project evaluation may be stated in one of two forms:

Market / Nominal Interest Rate (i): A rate which combines the effects

of interest and inflation.

Real Interest Rate (i): A rate from which the effects of inflation have

been removed.

Real Interest Rate (i) = Nominal Interest Rate (i) General Inflation Rate (f )

Nominal Interest Rate(i) = Real Interest Rate (i) + General Inflation Rate (f )

= Market Interest Rate Under Continuous

Compounding

& Purchasing Power

Project cash flows may be stated in one of two forms:

1- Actual / Current Dollars (An): Dollars that reflect

the inflation or deflation rate.

2- Constant / Real Dollars (An): Year 0 dollars

I - Actual / Current Dollar Analysis

- If the cash flow is estimated in terms of the dollars that will be used in

n years, we say the amounts are in actual (or year-n, or current) dollars.

-If the cash flow is estimated in terms of constant-value dollars, we say

the amounts are in real (or year-0, or constant) dollars.

To calculate the present value of actual dollars, we can use a twostep or a one-step method:

1.Convert any cash flow elements in actual dollars into

2. Calculate the present value of constant dollars by discounting

at the real interest rate (i).

Adjusted-discount MethodOne Step:

1. Compute the nominal / market interest rate (i).

2. Use the market interest rate (i) directly to find the present

value.

Step 1:

Convert actual dollars to Constant dollars

Multiplied by

Deflation Factor

(or year 0) Dollars

-$75,000

-$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

31

Step 2:

Convert Constant dollars to Equivalent Present value

n

year 0) Dollars

Multiplied by

Discounting Factor

Equivalent Present

value

-$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

32

Deflation Method:

Converting actual dollars to constant dollars and then to equivalent

present value

n=0

Actual

Dollars

Constant

Dollars

Present

value

-$75,000

-$75,000

n=1

n=2

n=3

n=4

n=5

$30,476

$28,218

-$75,000

$27,706

$26,761 $21,288

$16,295

$45,268

33

Pn

An

(1 f ) n

Pn

(1 i ') n

Step 2

An

An

n

(1 i )

(1 f ) n (1 i' )

Step 1

(1 i ) (1 i )(1 i' )

An

(1 f ) n (1 i ' ) n

An

(1 i ) n

1 i' f i' f

An

(1 f ) (1 i' )

n

i i ' f i ' f

34

Adjusted-Discounted Method

n

Multiplied

by

Equivalent

Present value

-$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

P n = An / (1+i) n = An (1+i) - n

i i' f i' f

0.10 0.05 ( 0.10 )( 0.05)

15.5%

- $75,000

$27,706

$26,761

$21,288

$16,295

$28,218

= $32,000 (P/F,

15.5%, 1)

$35,700

3

4

= $58,000 (P/F, 15.5%, 5)

$32,800

$32,000

= $32,800 (P/F,

15.5%, 3)

= $35,700 (P/F,

15.5%, 2)

Adjusted-discount method

$58,000

$29,000

0

5

$45,268

36

Converting actual dollars to present value dollars by applying the

market interest rate

n=0

Actual

Dollars

-$75,000

n=1

n=2

n=3

n=4

n=5

i i f if 15.5%

Present

value

$28,218

-$75,000

$27,706

$26,761 $21,288

$16,295

$45,268

37

Two Steps Approach:

Step 1- Convert any cash flow elements in constant dollars

into actual dollars by using the general inflation rate (f ).

Step 2- Use the market interest rate (i) to find the equivalent

present value.

38

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

V2 = $229,211

Let V1 = V2 and solve

for C:

C = $2,888.48

40

Item

Rate of Return

and NPW

Effects of Inflation

Unless revenues are

sufficiently increased to keep

pace with inflation, tax effects

and/or a working capital drain

result in lower rate of return or

lower NPW.

41

_

f 10%

return should be based on

constant dollars.

If the rate of return is

computed based on actual

dollars, the real rate of

return can be calculated as:

i'

1 i

_

1 f

1 0.3134

1

1 0.10

19.40%

Net cash

flows in

actual

dollars

Net cash

flows in

constant

dollars

0

1

2

3

4

-$30,000

13,570

15,860

13,358

13,626

-$30,000

12,336

13,108

10,036

9,307

IRR

31.34%

19.40%

42

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