9 - Price Changes

Engineering Economics
ECO 1192
Lecture 9: Decision-making with Price Changes
Claude Thoret
University of Ottawa
Recommended Reading
Fraser et al. Chapter 9
Newnan et al. chapter 14
9. Price Changes
Before- and After-Tax Cash Flows

END OF YEAR
0
Annual revenues (AR) (Actual $)

Annual costs (AC) (Actual $)
1. BTCF "Operations" (Actual $)
AA
BB
2. BTCF "SV" (Actual $)
CC
3. BTCF "Working Capital" (Actual $)

4. Total BTCF (Actual $)
DD
5. BTCF "Operations" (Constant $)
EE
6. BTCF "SV" (Constant $)
FF
7. BTCF "Working Capital" (Constant $)

8. Total BTCF (Constant $)
9. Annual Depreciation
GG
10. Interest on loan
HH
II
11. Taxable Operating Income

12. Taxes on Operating Income
JJ
13. Capital gains
KK
14. Taxes on capital gains

15. Recaptured depreciation
LL
16. Taxes on recaptured dep.
MM
17. ATCF "Operations" (Actual $)
NN
18. ATCF "Operations" (Constant $)

19. ATCF "SV" (Actual $)
20. ATCF "SV" (Constant $)
21. ATCF "Working Capital" (Actual $)
22. ATCF "Working Capital" (Constant $)
23. Total ATCF (Actual $)
24. Total ATCF (Constant $)
OO
PP
25. (=R10.) Interest on loan
QQ
RR
26. Loan repayment
SS
27. CFOE (Actual $)
TT
28. CFOE (Constant $)
UU
Introduction
In all project analyses thus far, the prices of
all goods and services were constant.

In the real world, prices are not constant,
sometimes increasing (inflation) and
sometimes decreasing (deflation)
Price changes can have significant effects on
the value or worth of an investment; hence,
they must be factored in an engineering
economic study
9. Price Changes
Measuring Inflation
Consumer Price Index
basket of consumer goods and services used
to track changes in prices on a monthly basis
Wholesale Price Index (tracks the prices of
wholesale goods)
GDP Implicit Price Deflator (tracks price
changes for all final goods and services
produced by an economy)
Published quarterly and annually
9. Price Changes
Consumer Price Index (CPI)
9. Price Changes
Your house .
1.
2.
3.
4.
Purchased in 1990 for $150,000

Market value in 2005 (15 years later) is $225,000
The annual inflation rate has been, on average, 2%.
Did your purchasing power increase between 1990
and 2005?
Real value of your house in 2005 in 1990 dollars
= $225,000(1+inflation rate)-15
= $225,000(1+0.02)-15 = $167,178
Answer: YES (real value in 2005 > real value in 1990).
9. Price Changes
Example: John and Mary

John and Mary married five years ago
following their graduation from U of O.

Their joint income in their first year as a
couple was $80,000.
the CPI for that year was (hypothetically)
105.8
Five years later, the CPI reached 133.9. What
must be the joint income of the couple to

maintain the purchasing power of 5 years
earlier?
9. Price Changes
Bonds and Inflation

$60,000 10-year Canada bonds are currently on sale
by Speedy Brokers Inc.

The rate of interest is 8% annually, payable
semiannually.
Bondholders expect
A return of 6% per year compounded semiannually
Inflation to be constant at 2% every 6 months.
How much should a purchaser pay

Without any adjustment for inflation
When inflation is considered
9. Price Changes
Example: Bond Rates of Return

A corporate bond
has a current price of $90,000

pays $10,000 annually for 10 years
If inflation is expected to be 5% forever

1. What is the bonds actual before-tax rate of return?
2. What is the bonds actual after-tax rate of return if the
tax rate is 30%?
3. What is the bonds real before-tax rate of return?
4. What is the bonds real after-tax rate of return if the
tax rate is 30%?
9. Price Changes
10
Causes of Inflation
Money supply
Growth in the money supply (currency and bank
deposits) exceeds the growth of goods and services
Exchange rates
Value of one currency in terms of another currency;
changes may affect the cost of purchasing goods and
services from other countries
Cost-push inflation
Increases in production costs (wages) higher prices
Demand pull inflation
the demand for goods and services grows faster than
their production
9. Price Changes
11
Why bother with inflation?

Repercussions on the purchasing power of money
purchasing power (or value) of money declines if
prices increase and cash flows (including weekly

wages) are not fully responsive (do not grow at the
same rate as prices)
future dollars are less valuable than today or
present dollars
$100 today will have a purchasing power of
$90.91 in 1 year if prices increase by 10 per
cent during the year or
$62.10 in 5 years
9. Price Changes
12
Why bother with inflation?

I nvestors are not satisfied with keeping pace with inflation
A successful investment must result in a net gain in buying
power (i.e., must exceed inflation)

Investors who purchase a corporate bond or make a
physical investment (such as a restaurant) must account for
the impact of price changes in their decision-making
Two rates of return are important in an investment decision:
Total or combined rate = real rate + rate of inflation
Real (inflation-free rate)
Of course, an investor should not forget the impact of
income taxes on the return on investment must

determine her/his rate of return after adjusting for
price changes AND after accounting for income
taxes.
9. Price Changes
13
Is Inflation problematic?
Yes. Unpredictable changes in the inflation rate
redistribute income in arbitrary ways between

employers and workers, between borrowers and
lenders ...
A high inflation rate is problematic because it
diverts resources from productive activities to the
unproductive activity of forecasting inflation
An engineer allocates much of her time to

forecasting inflation instead of producing the goods
and services to meet the needs of society.
9. Price Changes
14
Rates of interest
Nominal (or actual)
Combination of the real rate and the rate of
inflation
Real (or constant)
Inflation-free rate of interest
In a zero (no) inflation world, the minimum rate
required for you to substitute future
consumption for current consumption
Save now to increase future consumption

About 2%
9. Price Changes
15
Real rate of interest

Important to state future $ in terms of a base or
reference year
Note that base year dollars can be stated as real or
constant dollars (for example, year 2000 dollars)
Non base-year dollars (such as year 2001 dollars)
can be stated as nominal or current dollars
For the base year, the PW of real dollars (inflationfree dollars) will equal the PW of nominal dollars
(dollars containing inflation)
See next slide for the conversion of nominal dollars
for any year (other than the base year) to equivalent
real dollars (i.e., inflation-free dollars)
9. Price Changes
16
Real rate of interest

Let $F be the future worth of $P today
(containing both inflation and a real rate of return)
To remove inflation from these future dollars ($F):
F' = F/(1+f) where f is the inflation rate
To bring these dollars to now or today $ adjust as follows
P = F'/(1+ir)
Therefore, the current (i.e., now) real dollars are given by
P = F/{(1+f)(1+ir)}
where (1+ic) = (1+f)(1+ir) or ic = (1+f)(1+ir)-1
Therefore,
ir = {(1 +ic) /(1 + f)} - 1

f = inflation rate; ir = real rate; ic = market rate
9. Price Changes
17
Real (constant) and current (actual) $
You invested $1,000 in a GIC from the Trust Me Company exactly five
years ago today.
No annual interest was paid to you over the years as the interest
income was reinvested automatically by the financial institution.
Today, you received a cheque for $1,500 which represents
The reimbursement off the $1,000 invested 5 years ago
Interest income generated by your $1,000 investment
If inflation was 4% throughout the 5 years, what is the purchasing
power of the $1,500 today relative to their purchasing power 5 years
ago?
= 1,500(P/F,inflation rate, 5) = 1,500(P/F,4%,5)
= $1,232.89
$1,500 is required today to buy what $1,232.89 could buy 5 years
ago (or about 83%); or
$1,217 is required today to buy what $1,000 could buy 5 years ago.
9. Price Changes
18
MARR and Cash Flows

Given:
Annual inflation rate = 3%
Nominal interest rate
without risk = 5%
First cost (P) = $3,000 on
January 1, 2001 (same as
December 31, 2000)
Cash flows in January 1,
2001 dollars (i.e., real or
constant dollars)
Real interest rate
= 5% - 3% = 2%
9. Price Changes
December
31
Cash Flows
2000
-3 000
2001
+1 500
2002
+1 500
2003
+1 500
2004
+1 500
19
MARR and Cash Flows

Given:
Annual inflation rate = 3%
Nominal interest rate
without risk = 5%
First cost (P) = $3,000 on
January 1, 2001 (same as
December 31, 2000)
Cash flows in actual
dollars (i.e., at the
prevailing price of each
year)
9. Price Changes
December
31
Cash Flows
2000
-3 000
2001
+1 500 (1.03)
= 1 545
2002
+1 500 (1.03)2
= 1 591
2003
+1 500 (1.03)3
= 1 639
2004
+1 500 (1.03)4
20
= 1 689
Example
An investor wants a real return (i.e., inflation-free return) of 4%
on a $1,000 investment when the annual rate of inflation is 10%

$1,000 now must grow to $1,100 in one year just to
maintain today's purchasing power
In addition, there must be a 4% rate of return on the $1,100 to
meet the investors rate of return objective

The total rate of return for one year becomes
F = P(1+f)N(1+ir)N
= 1000(1.10)(1.04) = $1,144
(anything less would represent a return on investment less than
4% in real terms)
where
f = inflation rate
ir = real rate of return
ic= combined rate (rate with inflation)
9. Price Changes
21
Example: DVD Purchases

Johnny loves classical music and, on a recent
birthday, received a $1,000 gift which could

be used for investment purposes or to
purchase DVDs
DVDs currently sell for $20
The local bank pays 5.5% interest
compounded annually
Inflation (f) is expected to be 2% annually for
the next 10 years.

9. Price Changes
22

What is the market (or combined) interest
rate (iC)? (Bank rate = Market rate = 5.5%)

What is the real (inflation-free) interest rate
(ir)?
(1+ic) = (1+ir)(1+f); (1+ir) = (1+ic)/(1+f)
ir = (1+ic)/(1+f) 1
= [(1+0.055)/(1+0.02)] - 1
= 0.0343 or 3.43% (precise rate)
9. Price Changes
23

How many DVDs could Johnny purchase today?
$1,000/$20 = 50 DVDs
How many DVDs could Johnny purchase in 1 year?
{1,000(F/P,5.5%,1)}/{20(F/P,f=2%,1)}
1055/20.40 = 51.71 DVDs
Since the nominal interest rate (5.5%) > inflation rate
(2%), the purchasing power of the $1,000 (in terms of

purchasing DVDs) would grow during the year.
Note that the percentage increase in the capacity to
purchase DVDs is (51.71-50)/50 = 0.0343 or 3.43%
(= inflation-free rate)
9. Price Changes
24
Discount Rate and Cash Flows
Cash Flows
Current $
Discount
Rate (%)
Current
(nominal)
Constant
(real)
Discount Rate (%)

Accurate
Approximate
= (1+f)(1+r) 1
=r+f
= [(1+c)/(1+f)] -1
=cf
Constant $
Current
Constant
X
9. Price Changes
25
Your turn!!!!
Determine the rate of inflation during a
decade if the price of a computer (driven

exclusively by inflation) doubled during the
decade?
8. VAN, flux montaires et taux d'actualisation
26
Your turn!!!!
Determine the rate of inflation during a
decade if the price of a computer (driven

exclusively by inflation) doubled during the
decade?
F = P(1+i)N
2P = P(1+i)10
2 = (1+i)10
20.1 = (1+i)10/10
i = 0.0718 7.18 %
27
Your turn!!!!
During a specific 5-year period, the market
rate of interest was 12% and the rate of

inflation was 5%.
How many dollars would be required after 5
years to maintain the purchasing power of
$2,000 at the beginning of the 5-year period?
28
Your turn!!!!
During a specific 5-year period, the market
rate of interest was 12% and the rate of

inflation was 5%.
How many dollars would be required after 5
years to maintain the purchasing power of
$2,000 at the beginning of the 5-year period?
F = P(1+i)N
F = 2,000(1+0.05)5
F = 2,552 dollars
29
Example 1
P = 1,000; F = 2,000; N = 4 years;
f = 10% (inflation rate); tax rate (t) = 0 (No taxes)
Find i c and i r
From F = P(1+ic)N
2000/1000 = (1+ic)4
Solve for ic: ic = 0.189 or 18.9% (with inflation)
From ir = [(1 +ic) /(1 + f)] - 1
= [(1+0.189)/(1+0.1)] - 1 = 0.081 or 8.1% (inflationfree)
9. Price Changes
30
Example 2
Assume that $5,000 is deposited each year-end in an
account earning interest at 10 percent per year
over a 5-year period. During this period, inflation is
expected to remain at 6 percent per year.
Determine the dollar amount in the fund at the end
of five years (the future worth after five years in
actual dollars)?
Future Worth = 5000(F/A,10%,5)
= $30,525 (actual or current dollars i.e., in dollars 5
years from now)
9. Price Changes
31
Example 2 (contd)
Given the eroding effect of inflation on
purchasing power, what is the value of this fund
in constant (real) dollars after five years?
$30,525(P/F,inflation,5)
= 30,525(P/F,6%,5)
= $22,810 [inflation-free dollars]
9. Price Changes
32
Example 2 (contd)
What is the real (inflation-free) rate of return on
this investment?
Real interest rate = ir = [(1 +ic)/(1 + f)] - 1
= [(1+0.1)/(1+0.06)] - 1
= 0.03774 or 3.774%
(the rate at which the investors purchasing power
increased during the 5-year period)
9. Price Changes
33
Example 3
Engineering Press is offering several subscription packages to
its influential Journal of Engineering Economics:

1 year for $40
2 years for $74
3 years for $109
Inflation is expected to be 5% annually for the next decade.
You are an avid reader of this Journal and plan to purchase it
forever.
Whats the best subscription deal if current market rates are
10% compounded annually and a subscription MUST be paid in
full at the beginning of a subscription period?
9. Price Changes
34
Example 3 (contd)
Year
Option 1
Option 2
Option 3
40
74
109
42
--
--
44.10
81.59
--
46.31
--
126.18
48.62
89.95
--
51.05
--
--
9. Price Changes
35
Example 3 (contd)
Find the PW of each subscription option:
Annual subscription : 40+42(P/F,10%,1)
+44.102(P/F,10%,2)+46.31(P/F,10%,3)
+48.62(P/F,10%,4)+51.05(P/F,10%,5)
= $214.32 (most expensive as expected)
Two-year subscription:
74 +81.59(P/F,10%,2)+89.95(P/F,10%,4)
= $202.87 (best deal)
Three-year subscription: 109+126.18(P/F,10%,3)
= $203.80
9. Price Changes
36
Example 4
Exactly 75 years ago today, Farmer Billy
Cash stored $1,000 (in dollar bills) in a bag of

wheat. During these years, inflation was 5%
annually.
What are their actual- and real-dollar values
today?
Actual dollar value = $1,000
Real-dollar value = 1,000(P/F,5%,75)= $25.75
($1,000 today can buy what $25.75 could buy

75 years ago)
9. Price Changes
37
Example 4 (contd)
Instead of storing $1,000 in a bag of wheat,
Farmer Bill could have purchased a GIC from

the TRUST ME Co. which paid 6% per year.
What would be the actual and real dollar
equivalents of the $1,000? [Inflation is still 5%
annually]
Actual dollar value = $1,000(F/P,6%,75)
= $79,057
Real-dollar value = 79,057(P/F,inflation,75)
= $2,036 [Which is much better than $25.75]
GIC Guaranteed Investment Receipt
9. Price Changes
38
Example 4 (contd)
Instead of storing the $1,000 in a bag of wheat or
purchasing a GIC, Farmer Bill could have invested in

a stock market index fund that grew by 12% annually
during this period. What would be the actual and real
dollar equivalents of the $1,000 invested in a stock
index fund? [Inflation is 5% annually]
Actual dollar value = $1,000(F/P,12%,75)
= $4,913,056
Real-dollar value = 4,913,056(P/F,inf,75)= $126,519
[Which is much better than $25.75 in the bag of wheat
and $2,036 in a GIC]
9. Price Changes
39
Cash Flows
Key issue: are cash flows
Annual receipts
Annual operating and maintenance costs
fully or partially responsive to inflation i.e., do

they grow in whole or in part with inflation?
Fully
Cash flows grow at the inflation rate.
Partially
cash flows grow by a fraction of the inflation rate
Cash flows are independent of the inflation
rate.
9. Price Changes
40
Example 5
Annual Interest Income
= 1,000@15% = $150
Inflation is 10% annually
$1,000 bond investment is fully refunded
(without risk of default) after 3 years
N = 3 years
Find ic and ir
9. Price Changes
41
Example 5 (contd)
Using the Present Worth Approach:
1000 = 150(P/A,i*,3)+ 1000(P/F,i*,3)
Solve for i*: i* = 15% (=ic)
From ir = [(1 +ic) / (1 + f)] 1, ir
= [(1 +0.15) / (1 + 0.1)] 1
= 0.0455 or 4.55%
9. Price Changes
42
Example 5 (with 30% tax rate)

Solve for ic and ir
Using the Present Worth Approach
1000 = 150 (1-0.3)(P/A,i*,3)+ 1000(P/F,i*,3)
i* = 10.5% (=ic)
From
ir = (1 +ic) /(1 + f) - 1
ir = (1 +0.105) /(1 + 0.1) - 1
ir = 0.0045 or 0.45%
(compare with 4.55% on previous slide)

9. Price Changes
43
Example 6
A = Annual interest income is fully responsive
to inflation
Inflation (f) = 10%
P = $1,000 which is also fully responsive to
inflation
F = $1,000
N = 3 years
Find ic and ir
9. Price Changes
44
Example 6 contd
Using the Present Worth Approach
1000 = 150(1+f)(P/F,i*,1)
+ 150(1+f)2(P/F,i*,2)
+ 150(1+f)3(P/F,i*,3) + 1000(1+f)3(P/F,i*,3)
Solve for i*: i* = 26.5% (=ic)
From ir = (1 +ic) /(1 + f) - 1
ir = (1 +0.265) /(1 + 0.1) - 1
= 0.15 or 15.0%
9. Price Changes
45
Example 7 Education Fund

You wish to set up an education fund TODAY for a child who will
attend college in 10 years.

Each of the 4 college years will cost $9,000 in today dollars.
Annual college costs are fully responsive to price changes and
inflation is projected to be 8% per year for the next 50 years.
The education fund is expected to earn 12% interest
compounded annually.
Assume that annual college payments are made in a lump sum
at the beginning of each of the four (4) academic years.
How much money must you deposit in the

education fund at the end of each of the next 10
years (with the first deposit in one year from
today)?
9. Price Changes
46
Example 7 Education Fund

College
Year
Cost of College
(Actual College Year
Dollars)
PW
(at the beginning of the First
College Year)
First
9000(F/P,8%,10) = $19,431
19,431(P/F,12%,0) = $19,431
Second
9000(F/P,8%,11) = 20,985
20,985(P/F,12%,1) = 18,737
Third
9000(F/P,8%,12) = 22,664
22,664(P/F,12%,2) = 18,068
Fourth
9000(F/P,8%,13) = 24,477
24,477(P/F,12%,3) = 17,422
TOTAL = $87,557
TOTAL = $73,658
The 10-year annuity becomes: A = F(A/F,12%,10)

73,658(0.057) = $4,199
9. Price Changes
47
Your new job

You are graduating this Fall and have been to several
job interviews with potential employers.

You received three (3) job offers in todays mail
(starting date is January 3, 2007 in each case)
Offer A: $50,000 annually in January 3, 2008
purchasing power
Offer B: $49,000 the first year followed by
annual increases of $3,000
Offer C: $55,000 annually for the next 5 years
9. Price Changes
48
Your new job

Economic intelligence tells you that inflation
will be 6% annually for the next 10 years.

If you are seeking a real MARR = 8%, which
plan would you select based on
A 4-year period of analysis
A fully-paid salary on May 1 of the next four (4)
years
9. Price Changes
49
Your new job

Offer A
PW(iC = 14.48%) = 50,000
+ 50,000(F/P,6%,1)(P/F,14.48%,1)
+ 50,000(F/P,6%,2)(P/F,14.48%,2)
+ 50,000(F/P,6%,3)(P/F,14.48%,3)
+ 50,000(F/P,6%,4)(P/F,14.48%,4)
= $188,335
If inflation=6% and you are seeking an 8% real increase, then
iC = (1+f)(1+ir) 1 = (1.06)(1.08) - 1 = 0.1448
9. Price Changes
50
Your new job

Offer B
PW(iC = 14.48%) = 49,000
+ 49,000(P/A,14.48%,3)
+ 3,000(P/G,14.48%,3)
= $183,929
9. Price Changes
51
Your new job

Offer C
PW(iC = 14.48%)
= 55,000 + 55,000(P/A,14.48%,4)
= $186,661
Summary:
PW (Offer A) = $188,335
PW (Offer B) = $183,929
PW (Offer C) = $186,661
9. Price Changes
52
Project Analysis Example 1

1.
2.
3.
4.
5.
Annual inflation (f) = 10%

No debt capital (r=0)
Straight line depreciation
SV = 0
Cash flows are fully responsive to inflation
(i.e., they increase by 10% each year)
9. Price Changes
53

Y
e BTCF
a nominal
r
BTCF
real
Interest
on
Debt
AED
Taxable
Income
Income
Taxes
ATCF
nominal
ATCF
real
0
-2991
-2991
--
--
--
-2991
-2991
1100
1000
598
502
251
849
771.7
1210
1000
598
612
306
904
747.1
1331
1000
598
733
367
964
724.3
1464
1000
598
866
433
1031
704.2
1611
1000
598
1013
507
1104
685.5
NO
DEBT
9. Price Changes
AED = Annual
Equivalent Depreciation
54

Annual inflation = 10%;
Debt capital; debt Capital is 30% of P paid
back in 5 equal instalments

Interest on unpaid debt = 12%.
Depreciation Method: Straight Line
SV = $0
9. Price Changes
55

Year
BTCF
nom
(1)
BTCF
Real
(2)
Int.
on
Debt
(3)
Annual
Dep.
(4)
TI
(5)
IT
(6)
ATCF
Nom.
(7)
ATCF
Real
(8)
Debt
+
Princ
(9)
-2991
-2991
--
--
--
--
-2991
-2991
1100
1000
107.64
598
394
197
903
1210
1000
86.11
598
526
263
1331
1000
64.58
598
668
1464
1000
43.06
598
1611
1000
21.53
598
CFOE
Nom
(10)
CFOE
Real
(11)
--
2093.7
2093.7
820.9
287
616
560
947
782.6
265
682
563
334
997
749.1
244
753
566
823
412
1052
718.5
222
830
567
991
496
1115
692.3
201
914
568
TI = Taxable Income; IT = Income Taxes

9. Price Changes
56

Six (6) rates of return (%)
A. Before tax
nominal rate of return = 32%
Real rate of return = 20%
B. After-tax
nominal rate of return = 19%
C. Owner Equity
Nominal rate of return = 22%
9. Price Changes
57
Debt Ratio and Return on Equity
9. Price Changes
58
9. Price Changes
59
Investment Project
A firm is considering the purchase of a truck
for $300,000 fully installed.

The truck is expected to last 3 years with a
salvage value of $100,000 at that time.
Revenues from operations will be $250,000
each year and operating and maintenance
costs will be $75,000 each year
9. Price Changes
60
Investment Project
1.
2.
3.
4.
5.
6.
7.
8.
9.
Depreciate the truck using the DB method (d=25%)

The half-year rule does not apply.
Before-tax with inflation interest rate = 20%.
Before-tax inflation-free interest rate = 15%.
After-tax with inflation interest rate = 10%.
After-tax inflation-free interest rate = 5%.
Annual inflation rate = 5%.
Tax rate = 50%
The firm gets a $100,000 loan (at a 10% rate of
interest) which is repaid as follows: next slide
9. Price Changes
61
Investment Project
The firm gets a $100,000 loan (at a 10% rate of interest)
which is repaid as follows:
Year-end Repayment
Year 1 : 30%
Year 2 : 30%
Year 3 : 40%
9. Price Changes
62
Years
Item
1. BTCF (Actual $)
300,000
175,000
175,000
175000+
100000
2. BTCF (Constant $)
300,000
166,667
158,730
237,555
3. Interest on Loan
10,000
7,000
4,000
4. Depreciation
75,000
56,250
42,188
5. Taxable Income
90,000
111,750
128,812
6. Taxes Payable
45,000
55,875
64,406
110,594
+71,093.7
=181,687.7
7. ATCF (Actual $)
300,000
130,000
119,125
8. ATCF (Constant $)
300,000
123,810
108,050
156,948.7
9. Repayment of Loan
30,000
30000
40,000
3. Interest on Loan
10,000
7000
4,000
10. CFOE (Actual $)
200,000
90,000
82125
112,948.7
200,000
9. Price Changes
85,714
74,49063
97,569.3
Table Rows (previous slide) for Rate of

Return Calculations
1. BTCF (Actual $)
Rate of Return Calculations
ROW
Current $ Before-Tax Cash Flow
Constant $ Before-Tax Cash Flow
Current $ After-Tax Cash Flow
Constant $ After-Tax Cash Flow
2. BTCF (Constant $)
3. Interest on Loan
4. Depreciation
5. Taxable Income
6. Taxes Payable
7. ATCF (Actual $)
8. ATCF (Constant $)
9. Repayment of Loan
Current $ Owner Equity

Constant $ Owner Equity
9. Price Changes
10
11
3. Interest on Loan
10. CFOE (Actual $)
64
Problem: Investment Project

After-tax inflation-free NPW of project
From the ATCF real dollar row (row 8):
-300,000 + 123,810(P/F,5%,1)
+ 108,050(P/F,5%,2) + 156,948.7(P/F,5%,3)
= $51,490
Owner Equity NPW in after-tax inflation-free dollars
From the CFOE real dollar row (row 11):
= -200,000 + 85,714(P/F,5%,1)
+ 74,490(P/F,5%,2) + 97,569.3(P/F,5%,3)
= $33,477
9. Price Changes
65
Problem: Investment Project

Rates of Return
Cash Flow
IRR (%)
BTCF (nominal or actual)
43
BTCF (constant or real)
37
ATCF (nominal or actual)
19
ATCF (constant or real)
14
CFOE (nominal or actual)
19
CFOE (constant or real)
14
9. Price Changes
66
Example: John and Mary

John and Mary married five
years ago following their

graduation from U of O.
Their joint income in their
first year as a couple was
$80,000.
the CPI for that year was
(hypothetically) 105.8
Five years later, the CPI
reached 133.9. What joint
income must the couple
have to maintain the
purchasing power of 5 years
earlier?
9. Price Changes
Their combined current

income must be:
= 80,000(133.9/105.8)
= $101,248
67
Bonds and inflation
$60,000 10-year Canada

bonds are currently on sale
by Speedy Brokers Inc.
The rate of interest is 8%
annually, payable
semiannually.
Bondholders expect
A return of 6% per year
compounded
semiannually
Inflation at 2% every 6
months.
How much should a
purchaser pay for a $60,000
bond
Without any adjustment
for inflation?
Adjusted for inflation?
9. Price Changes
Without inflation adjustment
Semi-annual interest =$2,400

Number of 6-month periods
= 10(2) = 20
PW=2,400(P/A,3,20)
+ 60,000(P/F,3,20) = $68,928
With inflation adjustment

ic= r+f+rf= 0.03+0.02+0.03(0.02)
= 0.0506
PW=2,400(P/A,5.06%,20)
+ 60,000(P/F,5.06%,20)
= $52,114
68
Bond Rates of Return
9. Price Changeshave a 30% income tax 69

Bondholders
rate
Marys Financial Investments

1. Mary bought a five-year $10,000 Guaranteed Income
Certificate (GIC) on January 1, 2007 (for which she

paid $10,000).
2. The GIC pays $1,000 in interest income each year on
December 31, 2007 to December 31, 2011 giving
Mary a 10% rate of return on her investment.
3. On December 31, 20011 (the GICs maturity date),
Mary will receive, in addition to her last interest
payment of $1,000, the full amount (i.e, $10,000) that
she invested on January 1, 2007.
4. During this period, inflation is expected to be 5
percent per year.
9. Price Changes
70

What is the combined (i.e., market interest) rate
of interest (to 2 decimals) on the GIC?
1. 5.00%; 2. 4.76%; 3. 10.00%
4. 15.00%; None of the above answers
Answer: Market Interest Rate = 10%
1.
2.
3.
4.
Mary bought a five-year $10,000 Guaranteed Income Certificate (GIC) on January 1, 2007 (for which
she paid $10,000).
The GIC pays $1,000 in interest income each year on December 31, 2007 to December 31, 2011
giving Mary a 10% rate of return on her investment.
On December 31, 20011 (the GICs maturity date), Mary will receive, in addition to her last interest
payment of $1,000, the full amount (i.e, $10,000) that she invested on January 1, 2007.
During this period, inflation is expected to be 5 percent per year.
9. Price Changes
71

What is the real (inflation-free) rate of
interest (to 2 decimals) on the GIC?
1. 5.00%; 2. 4.76%; 3. 5.24%; 4. 10.00%
5. None of the above answers
Ans. iR = [(1+IC)/(1+f)] 1= [1.10/1.05] 1 =
0.0476
1.
2.
3.
4.
she paid $10,000).
9. Price Changes
72

If Mary can reinvest the interest income from the GIC at
10% each year, what will be the future worth (on
December 31, 2009; to the nearest $100) of the
$10,000 investment (principal and interest income) in
constant (i.e., real or January 1, 2007 dollars)?
$16,100; 2. $12,600; 3. $11,500; 4. $10,000
Ans. $10,000[1.13/1.053] = $11,498 or $11,500
OR $10,000(1.0476)3 = $11,498 or $11,500
1.
2.
3.
4.
she paid $10,000).
9. Price Changes
73

If Mary can reinvest the interest income from
the GIC at 10% each year, what will be the
present worth (to the nearest dollar) of the
$10,000 investment in actual dollars on
January 1, 2007?
1. $16,672; 2. $10,000; 3. $11,513; 4. $0
5. None of the above answers.
Ans. $10,000[(1.1)5/(1.1)5] = $10,000
1.
2.
3.
4.
she paid $10,000).
payment of $1,000, the full amount
(i.e,
$10,000) that she invested on January 1,
9. Price
Changes
742007.

What is the actual dollar value of the 3 rd
$1000 interest payment (i.e., the payment
that Mary received on December 31, 2009)?
1. $1000; 2. $952.38; 3. $907.03; 4. $540.77
Ans. $1000
1.
2.
3.
4.
she paid $10,000).
9. Price Changes
75

What is the real or constant dollar value (i.e.,
in January 1, 2007 dollars) of the 4th $1000
interest payment?
1. $1000; 2. $823; 3. $907; 4. $541
Ans. 1000(P/F,5%,4) = $822.70
1.
2.
3.
4.
she paid $10,000).
9. Price Changes
76
Next Week: Lecture 10

Project Management
Fraser et al.* chapter 11
9. Price Changes
77
Engineering Economics
ECO 1192
Lecture 9: Decision-making with price changes
Claude Thoret
University of Ottawa

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Engineering Economics

Before- and After-Tax Cash Flows

Annual revenues (AR) (Actual $)

2. BTCF "SV" (Actual $)

3. BTCF "Working Capital" (Actual $)

5. BTCF "Operations" (Constant $)

6. BTCF "SV" (Constant $)

7. BTCF "Working Capital" (Constant $)

10. Interest on loan

11. Taxable Operating Income

13. Capital gains

14. Taxes on capital gains

16. Taxes on recaptured dep.

17. ATCF "Operations" (Actual $)

18. ATCF "Operations" (Constant $)

25. (=R10.) Interest on loan

26. Loan repayment

27. CFOE (Actual $)

28. CFOE (Constant $)

all goods and services were constant.

Consumer Price Index (CPI)

Purchased in 1990 for $150,000

Real value of your house in 2005 in 1990 dollars

Example: John and Mary

following their graduation from U of O.

Five years later, the CPI reached 133.9. What

must be the joint income of the couple to

Bonds and Inflation

by Speedy Brokers Inc.

How much should a purchaser pay

Example: Bond Rates of Return

has a current price of $90,000

If inflation is expected to be 5% forever

Why bother with inflation?

prices increase and cash flows (including weekly

Why bother with inflation?

power (i.e., must exceed inflation)

Of course, an investor should not forget the impact of

income taxes on the return on investment must

redistribute income in arbitrary ways between

An engineer allocates much of her time to

Save now to increase future consumption

Real rate of interest

Real rate of interest

ir = {(1 +ic) /(1 + f)} - 1

Real (constant) and current (actual) $

MARR and Cash Flows

MARR and Cash Flows

on a $1,000 investment when the annual rate of inflation is 10%

maintain today's purchasing power

In addition, there must be a 4% rate of return on the $1,100 to

meet the investors rate of return objective

Example: DVD Purchases

birthday, received a $1,000 gift which could

Inflation (f) is expected to be 2% annually for

the next 10 years.

Example: DVD Purchases

rate (iC)? (Bank rate = Market rate = 5.5%)

Example: DVD Purchases

(2%), the purchasing power of the $1,000 (in terms of

Discount Rate and Cash Flows

Discount Rate (%)

decade if the price of a computer (driven

8. VAN, flux montaires et taux d'actualisation