Inflation and Its Impact on Project

Cash Flows
Chapter 11
Contemporary Engineering Economics
Chapter 14
Engineering Economic Analysis
1
 Inflation and Its Impact on Project
Cash Flows
• Meaning and Measure of
Inflation
• Equivalence
Calculations under
Inflation
• Effects of Inflation on
Project Cash Flows
• Rate of Return Analysis
under Inflation
2
Inflation and Economic Analysis

• What is inflation?

• How do we measure 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
Decrease in purchasing power (inflation)
Increase in purchasing Power (deflation)

4
 Purchasing Power
$100 $100

1990 1990 2001

You could buy 50 Big Macs You can only buy 40 Big
in year 1990. Macs in year 2001.

$2.00 / unit 25%

Price change
$2.50 / unit
due to
inflation
The $100 in year 2001 has only $80
worth purchasing power of 1990

5
 $100 $100

-2 -1 0 1 -2 -1 0 1

You could purchase You can now purchase

63.69 gallons of 80 gallons of unleaded
unleaded gasoline gas.
a year ago.

20.38%
$1.57 / gallon $1.25 / gallon
Price change due to
deflation
6
 Price Increase Due to Inflation
Item 1967 Price 2000 Price % Increase
Consumer price index (CPI) 100 512.9 413
Monthly housing expense $114.31 $943.97 726
Monthly automobile expense 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 0.90 800
Men’s dress shirt 5.00 39.00 680
Postage (first-class) 0.05 0.33 660
Annual public college tuition 294.00 3,960.00 1,247
7
 Inflation Terminology - I
• Producer Price Index: a statistical measure of industrial price
change
• Consumer Price Index: a statistical measure of change, over
time, of the prices of goods and services in major expenditure groups
—such as food, housing, apparel, transportation, and medical care—
typically purchased by urban consumers
• Average Inflation Rate (f): a single rate that accounts for the
effect of varying yearly inflation rates over a period of several years.
• General Inflation Rate (_): the average inflation rate
f items in the market basket.
calculated based on the CPI for all

8
 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.

Market basket
Base Period (1967) 2001
$100 $512.9
CPI for 2001 = 512.9
9
 Selected Price Indexes
Year New CPI Old CPI Gasoline Steel Passenger Car
Base Period 1982-84 1967 1982 1982 1982
1991 135.2 405.1 66.9 110.6 124.2
1992 139.5 417.9 65.6 107.1 127.3
1993 144.0 461.2 67.9 106.7 129.8
1994 147.4 441.4 59.5 111.9 133.3
1995 152.2 455.0 67.7 121.7 134.0
1996 156.6 468.2 76.4 114.9 135.2
1997 160.2 479.7 72.7 116.4 135.2
1998 162.5 487.1 54.0 115.4 132.2
1999 166.2 497.8 64.4 105.3 121.4
2000 171.2 512.9 92.6 109.8 133.4
10
 Average Inflation Rate (f)
Fact:
Base Price = $100 (year 0)
Inflation rate (year 1) = 4%
Inflation rate (year 2) = 8%
Average inflation rate over 2 years?

Step 1: Find the actual inflated price at the end of year 2.

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

Step 2: Find the average inflation rate by solving the

$112.32
following equivalence equation.
2 0 1
$100 ( 1+ f) = $112.32 2
f = 5.98% $100
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 General Inflation Rate (f)
What goods and services does the CPI cover?
The CPI represents all goods and services purchased for consumption by the reference
population. It is classified in all expenditure items into more than 200 categories,
arranged into eight major groups. Major groups and examples of categories in each are
as follows:
•FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service
meals, snacks)
•HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom
furniture)
•APPAREL (men's shirts and sweaters, women's dresses, jewelry)
•TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
•MEDICAL CARE (prescription drugs and medical supplies, physicians' services,
eyeglasses and eye care, hospital services)
•RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);
•EDUCATION AND COMMUNICATION (college tuition, postage, telephone services,
computer software and accessories);
•OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other
personal services, funeral expenses).
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 Average Inflation Rate
Item 1967 Price 2000 Price Average Inflation
Rate
Consumer price index (CPI) 100 512.9 5.07%
Monthly housing expense $114.31 $943.97 6.61
Monthly automobile expense 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
Men’s dress shirt 5.00 39.00 6.42
Postage (first-class) 0.05 0.33 5.89
Annual public college tuition 294.00 3,960.00 8.19
13
 General Inflation Rate (f)
Average inflation rate based on the CPI
_
CPI n  CPI 0 (1  f ) n ,
1/ n
_
CPI n
f  1
CPI 0
_
where f  The genreal inflation rate,
CPI n  The consumer price index at the end period n,
CPI 0  The consumer price index for the base period.

14
 Example 13.2: Yearly and Average Inflation Rates

Year Cost
What are the annual inflation rates
0 $504,000 and the average inflation rate over 3 years?
1 538,000
2 577,000
3 629,500 Solution
Inflation rate during year 1 (f1):
($538,400 - $504,000) / $504,000 = 6.83%.
Inflation rate during year 2 (f2):
($577,000 - $538,400) / $538,400 = 7.17 %.
Inflation rate during year 3 (f3):
($629,500 - $577,000) / $577,000 = 9.10%.
The average inflation rate over 3 years is
$629,500 1/ 3
f ( )  1  0.0769  7.69%
$504,000
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 Inflation Terminology – II
• Actual 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.
• Constant Dollars (An’ ): Estimates of future
cash flows for year n in constant purchasing
power, independent of the passage of time (or
base period).

16
 Conversion
from Constant to Actual Dollars
_ _
An  A' n (1  f )  A' n ( F / P, f , n)
n

n3 $1,260
$1,000 _
f  8%

3
3
Actual
Constant
3 Dollars
Dollars $1,000 (1 + 0.08)
= $1,260

17
 Conversion from Constant to Actual
Dollars
Period Net Cash Flow in Conversion Cash Flow in
Constant $ Factor Actual $
0 -$250,000 (1+0.05)0 -$250,000
1 100,000 (1+0.05)1 105,000
2 110,000 (1+0.05)2 121,275
3 120,000 (1+0.05)3 138,915
4 130,000 (1+0.05)4 158,016
5 120,000 (1+0.05)5 153,154
18
 $120,000 $130,000
$110,000
$100,000 $120,000

0
1 2 3 4 5
Years

$130,000(1+0.05)4

$120,000(1+0.05)5
(a) Constant dollars
$100,000(1+0.05)

$120,000(1+0.05)3
$110,000(1+0.05)2
$250,00
0
$250,000(1+0.05)0

$138,915 $158,016
$121,275
$105,000 $153,154

0
1 2 3 4 5
Years
(b) Actual dollars
$250,000 19
 Conversion
from Actual to Constant Dollars
_ _
n
A' n  An (1  f )  An ( P / F, f , n)
n3 $1,260
$1,000 _
f  8%

3
3
Actual
Constant -3
$1,260 (1 + 0.08) Dollars
Dollars
= $1,000

20
 Conversion from Actual to Constant
Dollars
End of Cash Flow Conversion Cash Flow in Loss in
period in Actual $ at f = 5% Constant $ Purchasing
Power
0 -$20,000 (1+0.05)0 -$20,000 0%

1 20,000 (1+0.05)-1 -19,048 4.76

2 20,000 (1+0.05)-2 -18,141 9.30

3 20,000 (1+0.05)-3 -17,277 13.62

4 20,000 (1+0.05)-4 -16,454 17.73

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Equivalence Calculation Under Inflation
1. Types of Interest Rate
Market Interest rate (i)
Inflation-free interest rate (i’)
2. Types of Cash Flow
In Constant Dollars
In Actual Dollars
3. Types of Analysis Method
Constant Dollar Analysis
Actual Dollar Analysis
Deflation Method
Adjusted-discount method

22
 Inflation Terminology - III
• Inflation-free Interest Rate (i’): an estimate of the
true earning power of money when the inflation
effects have been removed (also known as real
interest rate).

• Market interest rate (i): interest rate which takes

into account the combined effects of the earning
value of capital and any anticipated changes in
purchasing power (also known as inflation-
adjusted interest rate).
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 Inflation and Cash Flow Analysis

•Constant Dollar analysis

- Estimate all future cash flows in constant dollars.

- Use i’ as an interest rate to find equivalent worth.

•Actual Dollar Analysis

- Estimate all future cash flows in actual dollars.

- Use i as an interest rate to find equivalent worth.

24
 Constant Dollar Analysis
• In the absence of inflation, all economic analyses
up to this point is, in fact, constant dollar analysis.
• Constant dollar analysis is common in the
evaluation of many long-term public projects,
because government 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.

25
 Actual Dollars Analysis

• Method 1: Deflation Method

- Step 1: Bring all cash flows to have

common purchasing power.
- Step 2: Consider the earning power.

• Method 2: Adjusted-discount Method

- Combine Steps 1 and 2 into one step.

26
 Step 1:

Convert actual dollars to Constant
dollars
n Cash Flows in Actual Multiplied by Cash Flows in
Dollars Deflation Constant Dollars
Factor
0 -$75,000 1 -$75.000
1 32,000 (1+0.05)-1 30,476
2 35,700 (1+0.05)-2 32,381
3 32,800 (1+0.05)-3 28,334
4 29,000 (1+0.05)-4 23,858
5 58,000 (1+0.05)-5 45,445

27
 Step 2:
Convert Constant dollars to Equivalent
Present Worth
n Cash Flows in Multiplied by Equivalent
Constant Dollars Discounting Factor Present Worth
0 -$75,000 1 -$75,000
1 30,476 (1+0.05)-1 27,706
2 32,381 (1+0.05)-2 26,761
3 28,334 (1+0.05)-3 21,288
4 23,858 (1+0.05)-4 16,295
5 45,445 (1+0.05)-5 28,218
$45,268

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 Deflation Method (Example 13.6):
Converting actual dollars to constant dollars and then to
equivalent present worth
n=0 n=1 n=2 n=3 n=4 n=5

Actual
Dollars -$75,000 $32,000 $35,700 $32,800 $29,000 $58,000

Constant -$75,000 $30,476 $32,381 $28,334 $23,858 $45,455

Dollars

Present $28,218
-$75,000
Worth $16,295
$26,761 $21,288
$27,706
$45,268
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 Adjusted-Discount Method
An
Pn 
(1  i ) n
An An An
Step 1  n
(1  f ) n (1  i ) n
(1  f ) n (1  i' )
Pn 
(1  i ') n (1  i )  (1  i )(1  i' )
Step 2
An  1  i'  f  i' f

(1  f ) n (1  i ' ) n

i  i ' f  i ' f
An
 n
(1  f ) (1  i' )
n

30
 Adjusted-Discounted Method
i  i'  f  i' f
 0.10  0.05  ( 0.10 )( 0.05)
 15.5%

n Cash Flows in Actual Multiplied Equivalent

Dollars by Present Worth
0 -$75,000 1 -$75,000

1 32,000 (1+0.155)-1 27,706

2 35,700 (1+0.155)-2 26,761

3 32,800 (1+0.155)-3 21,288

4 29,000 (1+0.155)-4 16,296

5 58,000 (1+0.155)-5 28,217

$45,268
31
 0

$45,268
$28,218
$16,295
$21,288
$26,761
$27,706
- $75,000
1
= $32,000 (P/F,
$32,000

15.5%, 1)
2
$35,700

= $35,700 (P/F,
15.5%, 2)
3
$32,800

= $32,800 (P/F,
15.5%, 3)
4
$29,000

= $29,000 (P/F, 15.5%, 4)

5
$58,000
Adjusted-discount method

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

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 Adjusted Discount Method: Example 13.7
Converting actual dollars to present worth dollars by
applying the market interest rate

n=0 n=1 n=2 n=3 n=4 n=5

Actual
Dollars -$75,000 $32,000 $35,700 $32,800 $29,000 $58,000

i  i  f  if  15.5%

Present $28,218
-$75,000
Worth $16,295
$26,761 $21,288
$27,706
$45,268

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 Effects of Inflation on Project Cash
Flows
Item Effects of Inflation
Depreciation Depreciation expense is
expense charged to taxable income in
dollars of declining values;
taxable income is overstated,
resulting in higher taxes
Note: Depreciation expenses are based on historical costs and
always expressed in actual dollars

34
 Item Effects of Inflation
Salvage value Inflated salvage value
combined with book values
based on historical costs
results in higher taxable gains.

35
 Item Effects of Inflation
Loan repayments Borrowers repay historical
loan amounts with dollars of
decreased purchasing power,
reducing the debt-financing
cost.

36
 Item Effects of Inflation
Working capital Known as working capital
requirement drain, the cost of working
capital increases in an
inflationary environment.

37
 Item Effects of Inflation
Rate of Return Unless revenues are
and NPW sufficiently increased to keep
pace with inflation, tax effects
and/or a working capital drain
result in lower rate of return or
lower NPW.

38
 Excel Example of an after-tax cash flow analysis
including differential inflation (Example 13.14)
INPUT: O&M Cost 13000 General Inflation rate 0.05
Salvage 1000 Inflation-free interest 0.2
Contract $ 23500 Market interest rate 0.26
Investment 15000 Income tax rate 0.4

Income Statement 0 1 2 3 4 5
Inflation rate
Revenues $23,500 $23,500 $23,500 $23,500 $23,500
Expenses:
O&M 8% $14,040 $15,163 $16,376 $17,686 $19,101
Depreciation $3,000 $4,800 $2,880 $1,728 $864
Taxable Income $6,460 $3,537 $4,244 $4,086 $3,535
Income taxes (40% ) $2,584 $1,415 $1,697 $1,634 $1,414
Net Income $3,876 $2,122 $2,546 $2,451 $2,121

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Cash Flow Statement 0 1 2 3 4 5
Inflation rate
Operating Activities:
Net Income $3,876 $2,122 $2,546 $2,451 $2,121
Depreciation $3,876
$3,000 $4,800 $2,880 $1,728 $864
Investment Activities: $3,000
Investment $15,000
Salvage 5% $1,276
Gains Tax $181
Net cash flow (actual$) $15,000 $6,876 $6,922 $5,426 $4,179 $4,442
Net cash flow (constant $) $15,000 $6,549 $6,279 $4,687 $3,438 $3,480
Equ. Present worth $15,000 $5,457 $4,360 $2,713 $1,658 $1,399
Net present worth $587

40
 Rate of Return Analysis under Inflation
_
f  10%

• Principle:True (real) rate of Net cash Net cash

return should be based on flows in flows in
n actual constant
constant dollars. dollars dollars
• If the rate of return is 0 -$30,000 -$30,000
computed based on actual 1 13,570 12,336
dollars, the real rate of 2 15,860 13,108
return can be calculated as: 3 13,358 10,036
1 i 4 13,626 9,307
i'  _ 1
1 f IRR 31.34% 19.40%
1  0.3134
 1
1  0.10
Not correct IRR
 19.40%
41
 Summary
• The Consumer Price Index (CPI) is a statistical
measure of change, over time, of the prices of
goods and services in major expenditure groups—
such as food, housing, apparel, transportation, and
medical care—typically 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.

42
• The general inflation rate (f) is an average
inflation rate based on the CPI. An annual general
inflation rate ( f ) can be calculated using the
following equation:
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.

43
• Project cash flows may be stated in one of two
forms
Actual dollars (An): Dollars that reflect the
inflation or deflation rate.
Constant dollars (A’n): Year 0 dollars
• Interest rates for project evaluation may be stated
in one of two forms:
Market interest rate (i): A rate which combines
the effects of interest and 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
44
• 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 of
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.

45