Effects of Inflation

Understanding the Impact of Inflation

Present Worth Calculations
Adjusted for Infl ation

Where i = real interest rate

f = inflation rate
EXAMPLE
• Glyphosate is the active ingredient in the herbicide Roundup®
marketed by Monsanto Co. Roundup has been a dependable
product used by farmers, municipalities, and suburbanites alike to
control weeds in fields, yards, gardens, streets, and parks.
Contributions to Monsanto’s revenue have been reduced
significantly by international dumping of generic glyphosate, as
announced in mid-2010.1 Monsanto’s sales price was decreased
from $16 to $12 per gallon to compete with the highly competitive
pricing, and it is expected that the international price will settle at
approximately $10 per gallon. Assume when the price was set at
$16 per gallon, there was a prediction that in 5 years the price
would inflate to $19 per gallon. Perform the following analysis.
(a) Determine the annual rate of inflation over 5 years to
increase the price from $16 to $19.
(b) Using the same annual rate determined above as the rate
at which the price continues to decline from the new $12
price, calculate the expected price in 5 years. Compare this
result with $10 per gallon that Monsanto predicted would be
the longer-term price.
(c) Provided Monsanto were somehow able to recover the
same market share as it had previously, and the same
inflation rate was applied to the reduced $12 per gallon
price, determine the price 5 years in the future and compare
it with the pre-dumping price of $16 per gallon.
(d) Determine the market interest rate that must be used in
economic equivalence computations, if inflation is
considered and an 8% per year real return is expected by
Monsanto.
Solution
• The first three parts involve inflation only—no
return on investments.
• (a) Solve Equation for the annual inflation rate
f with known constant-value and future
amounts.
b) If the price deflation rate is 3.5% per year, find the F value
in 5 years with P = $12.

The price will fall to exactly $10 per gallon after 5 years, as
Monsanto predicted.

(c) Five years in the future, at 3.5% per year inflation,

the price will be
(d) With inflation at 3.5% per year and a real return of 8% per year, Equation
results in a market rate of 11.78% per year.

if = 0.08 + 0.035 + (0.08)(0.035)

= 0.1178 (11.78% per year)
EXAMPLE 2
• A self-employed chemical engineer is on contract
with Dow Chemical, currently working in a relatively
high-inflation country in Central America. She wishes
to calculate a project’s PW
with estimated costs of $35,000 now and $7000 per
year for 5 years beginning 1 year from now with
increases of 12% per year thereafter for the next 8
years. Use a real interest rate of 15% per year to make
the calculations (a) without an adjustment for inflation
and (b) considering inflation at a rate of 11% per year.
Solution
• (a) Figure presents the cash flows. The PW
without an adjustment for inflation is found
using i = 15% and g = 12% in Equations for the
geometric series.
In the P/A factor, n / 4 because the $7000 cost in year 5 is the A1 term in Equation
b) To adjust for inflation, calculate the inflated interest rate by Equation [14.6] and use it to
calculate PW.

Comment
This result demonstrates that in a high-inflation economy, when
negotiating the amount of the payments to repay a loan, it is
economically advantageous for the borrower to use future
(inflated) dollars whenever possible to make the payments. The
present value of future inflated dollars is significantly less when
the inflation adjustment is included. And the higher the inflation
rate, the larger the discounting because the P/F and P/A factors
decrease in size.
 Cost
Estimation and
Indirect Cost
Allocation
Unit Method
The unit method is a popular preliminary estimation
technique applicable to virtually all professions. The
total estimated cost C T is obtained by multiplying the
number of units N by a per unit
cost factor u .

CT=uXN
EXAMPLE
Justin, an ME with Dynamic Castings, has
been asked to make a preliminary
estimate of the total cost to manufacture
1500 sections of high-pressure gas pipe
using an advanced centrifugal casting
method. Since a 20% estimate is
acceptable at this preliminary stage, a unit
method estimate is sufficient. Use the
following resource and unit cost factor
estimates to help Justin.
 Materials: 3000 tons at $45.90 per ton
Machinery and tooling: 1500 hours at $120 per hour
Direct labor in plant:
Casting and treating: 3000 hours at $55 per hour
Finishing and shipping: 1200 hours at $45 per hour
Indirect labor: 400 hours at $75 per hour

Solution
Apply Equation to each of the five areas and sum the
results to obtain the total cost estimate of $566,700.
Table provides the details.
Total Cost Estimate Using Unit Cost Factors
for Several Resource Areas,
Example
Cost Indexes

Where C t = estimated cost at present time t

C0 = cost at previous time t0
I t = index value at time t
I0 = index value at time t0
EXAMPLE
• In evaluating the feasibility of a major
construction project, an engineer is interested in
estimating the cost of skilled labor for the job.
The engineer finds that a project of similar
complexity and magnitude was completed 5
years ago at a skilled labor cost of $360,000. The
ENR skilled labor index was 3496 then and is now
5127. What is the estimated skilled labor cost for
the new project?
Solution
The base time t0 is 5 years ago. Using Equation , the present
cost estimate is
EXAMPLE
Sean, owner of Alamo Pictures, makes fact-based
documentaries about the Old West and sells them in a
variety of outlets, by mail, and online. He has decided
to expand into new areas and wants to make cost
estimates for three of the more significant labor costs
involved in making these types of films. The Director of
Finance of Alamo Pictures generated the annual
average hourly costs
(a) Make 2008 the base year, and determine the cost
indexes using a basis of 1.00. Comment on the trend of
each index over the years.
(b) Sean expects to utilize a lot of graphics services in 2014
for a planned documentary; however, it is the most rapidly
increasing cost component. The cost in 2010 was $78 per
hour; assume a worst-case scenario is that the graphics
index continues the same arithmetic trend it had from
2010 to 2011. Determine the hourly cost that he should
budget for in 2014.
Solution
(a) For each type of service, calculate It/I0 where t =
2005, 2006, . . . with 2008 as the base year 0. Table
presents the indexes. Observations about trend are
as follows:
Graphics labor cost: Constantly increasing over all
years. Stuntmen labor cost: Rising until 2009, then
stable. Actors labor cost: Higher in 2007 and 2008;
comparatively lower and stable in other years.
Average Hourly Costs for Three Services

Index Values with 2008 as Base Year

(b) The index in 2010 is 1.16. The increase to 2011 is 0.18; the
index value in 2014 will be
1.34 + 3(0.18) = 1.88. finds the expected, worst-case cost in
2014.