EQUIVALENCE

CALCULATIONS UNDER
INFLATION
ISE 307 Chapter 4
Dr. Samir Al-Amer Term 131

Inflation and Economic Analysis

What is inflation?

How do we measure inflation?

How do we incorporate (include) the effect of

inflation in equivalence calculation?

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 What is inflation?
Inflation is the rate of increase in the level of prices for goods and
services, which affects the purchasing value of money.
A loss in the purchasing power of money over time.
The same dollar amount buys less of an item over time.

Value of Money
Earning Power How much you currently make at your place of
employment plays a major part in your earning power.
Purchasing power The value of a currency expressed in terms of
the amount of goods or services that one unit of money can buy.

Purchasing Power
Decrease in purchasing power (inflation)
Increase in Purchasing Power (deflation)

Purchasing Power

$100 $100

2000 2000 2010

You could buy 50 Big Macs in You can only buy 40 Big Macs in
year 2000. year 2010.

25%
$2.00 / unit Price
$2.50 / unit
change
due to
inflation

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 Deflation
$100 $100

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

You could purchase 63.69 gallons You can now purchase 80 gallons
of unleaded gas a year ago. of unleaded gas.

20.38%
$1.57 / gallon $1.25 / gallon
Price change due to deflation

Inflation Terminology - I
Producer Price Index (PPI): a statistical measure of wholesale
industrial price change, compiled monthly by the BLS, to
evaluate wholesale price levels in the economy.

Consumer Price Index (CPI): a statistical measure of change,

over time, of the prices of goods and services in major
expenditure groups such as food and beverages, housing,
apparel, transportation, entertainment, medical care and
other goods and services typically purchased by city
consumers.

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 Inflation Terminology - I

Average Inflation Rate ( f ): a single rate that accounts

for the effect of unstable yearly inflation rates over a
period of several years.

General Inflation Rate ( f ): the average inflation rate

calculated based on the CPI for all items in the market
basket.

CONSUMER PRICE INDEX

Figure 4-1 Measuring inflation based on CPI

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 Consumer Price Indexes for 1963 and 2004

91.7 100 561.23

2004
1963 1967

Average inflation rate = 4.52%

561.23 91.70(1 f ) 41
f 41
6.1203 1
4.5176%

Measuring Inflation
Consumer Price Index (CPI) is a measure of the average change
over time in the price paid by city family for a set of consumer
goods and services. 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 (1982-84) 2009
$100 $179.9
CPI for 2009 = 179.9 %

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 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
$112.32
Step 2: Find the average inflation rate by solving the
following equivalence equation.
0 1
2
$100 ( 1+ f ) = $112.32 2
f = 5.98%
$100

Example 4.1
Calculating Average Inflation Rate

Item 2006 Price 2000 Price Average Inflation

(CPI) Base Period: 1982 - 84 = 100 F P Rate (%)
Consumer price index (CPI) $200.43 $171.20 2.66
Postage 0.39 0.33 2.82
Homeowners Insurance 617.00 500.00 3.57
Private college tuition and fees 22,218 15,518 6.16
Gasoline 2.56 1.56 8.61
Haircut 15.00 10.50 6.12
Car (Toyota Camry) 22,900 21,000 1.45
Natural gas (MBTU) 7.08 3.17 14.33
Baseball tickets 171.19 132.44 4.37
Health care (per year) 2,351.00 1,656.00 6.01

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 General Inflation Rate ( f )
This average inflation rate is calculated on the basis of CPI
for all items in the market basket. The market interest rate
is expected to respond to this general inflation rate. In
terms of CPI, we define the general inflation rate as
_
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.

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Example: Yearly and Average Inflation Rates

Year Cost
What are the annual inflation rates
0 $504,000
and
1 538,000 the average inflation rate over 3 years?
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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 ACTUAL VERSUS CONSTANT DOLLARS
Due to inflation, the purchasing power of the dollar changes
over time.

To compare dollar values of different purchasing power from

one period to another, they need to be converted to dollar
values of common purchasing power conversion from
actual to constant dollars or from constant to actual dollars.

To introduce the effect of inflation into our economic

analysis, we need to define two inflation related terms.

Inflation Terminology II
The effect of inflation into economic analysis
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. Usually, these
amounts are determined by applying an inflation rate to
base-year dollar estimates.

Constant (real) Dollars (A'n):

Represents constant purchasing power independent of
the passage of time. We will assume that the base year is
always time zero unless we specify otherwise.

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 Conversion from
Constant to Actual Dollars

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

n3 $1,260
$1,000
_
f 8%

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

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 Examples 4.3 & 4.4

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

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 Inflation Terminology - III

Inflation-free Interest Rate ( i' ): an estimate of the true

earning power of money when the inflation effects have
been removed.

This rate is known as real interest rate, and it can be

computed if the market interest rate and the inflation
rate are known.

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Inflation Terminology - III

Market interest rate ( i ) known as the nominal interest

rate, which takes into account the combined effects of the
earning value of capital (earning power) and any anticipated
inflation or deflation (purchasing power).

Most firms use a market interest rate (also known as

inflation-adjusted required rate of return) in evaluating
their investment projects.

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 Inflation and Cash Flow Analysis

Constant Dollar analysis (A' n) (inflation free interest rate i' )

All cash flow elements are given in constant dollars
Compute the equivalent present worth of constant dollars
(A' n) in year n.

In the absence of inflationary effect, we use i' to account

the earning power of the money.

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Inflation and Cash Flow Analysis

Actual Dollar Analysis (An) ( market interest rate i )

All the cash flow elements are estimated in actual dollars.
To find the equivalent present worth of this actual dollar
amount (An ) in year n.
We use two steps to convert actual dollars into equivalent
present worth dollars.

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 Actual Dollars (An ) Analysis
Method 1: Deflation Method

Convert actual dollars into equivalent constant dollars by

discounting with the general inflation rate, a step that
removes the inflationary effect. Now we can use i' to find
the equivalent present worth.

Method 2: Adjusted-discount Method

Combine two steps into one step, which performs deflation

and discounting in one step.

n Net Cash Flows

in Actual Dollars
Example:
0 -$75,000
Equivalence Calculation
1 32,000
when cash flows are
2 35,700
in actual dollars:
3 32,800
4 29,000
5 58,000
Deflation Method

Applied instrumentation, a small manufacturer of custom electronics to make

investment to produce sensors and control systems that have been requested by a fruit
drying company. The work would be done under a contract that would terminate in five
years. The project is expected to generate the above cash flows in actual dollars:
a) What are the equivalent constant dollars if the general inflation rate is 5% per year.
b) Compute the present worth these cash flows in constant dollars at i' = 10%

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 Solution: Step 1
Convert Actual dollars to Constant dollars

n Cash Flows in Multiplied by Cash Flows in

Actual Dollars Deflation Constant Dollars
Factor 5%
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

Step 2
Convert Constant dollars to Equivalent Present Worth

Multiplied by
n Cash Flows in Constant Discounting Factor Equivalent
Dollars Present Worth
i' = 10%
0 -$75,000 1 -$75,000
1 30,476 (1+0.10)-1 27,706
2 32,381 (1+0.10)-2 26,761
3 28,334 (1+0.10)-3 21,288
4 23,858 (1+0.10)-4 16,295
5 45,445 (1+0.10)-5 28,218
$45,268

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 Deflation Method (Example):
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
-$75,000
Worth
$27,706 $26,761 $21,288 $16,295 $28,218
$45,268

Adjusted-Discount Method
Perform Deflation and Discounting in One Step
An
Pn
1 i n
Step 1 An An

An
(1 f ) n
1 i n

1 f 1 i' n

Pn
(1 i ' ) n 1 i 1 f 1 i ' 1 f i ' i ' f

An i i ' f i ' f
Step 2
(1 f ) n (1 i ') n
i i f i f
An

_ _

1 f 1 i' n i f i(1 f )

i f
i
1 f

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Previous Example i i' f i' f
Adjusted - Discounted 0.10 0.05 (0.10)(0.05)
Method 15.5%

Cash Flows in Actual Multiplied Equivalent

n Dollars By (15.5%) 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

Graphical Overview on Adjusted Discount Method:

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 if 15.5%

Present $28,217
-$75,000
Worth $21,288 $16,296
$26,761
$27,706
$45,268

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 MIXED DOLLAR ANALYSIS
Consider situation that some cash flow elements are expressed in
constant (or todays) dollars.

In this situation, we convert all cash flow elements into same dollar
units (either constant or actual).

If the cash flow elements are all converted into actual dollars, we can
use the market interest rate i in calculating the equivalence value.

If the cash flow elements are all converted into constant dollars, we
can use the inflation-free interest rate i'

Example 4.7 illustrates this situation.

Example 4.7 Equivalence Calculation

with Composite Cash Flow Elements

Convert any cash flow elements in constant dollars into actual dollars.
Then use the market interest rate to find the equivalent present value.

Age College expenses College expenses

in todays dollars 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

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Required Quarterly Contributions to College Funds

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