CE 22

Ma. Brida Lea D. Diola

Objectives
— to discuss different methodologies for dealing with
price changes caused by inflation and deflation
— to develop and illustrate proper techniques to
account for these effects in engineering economic
analysis
Discussion Topics
— Meaning and Measures of Inflation
— Inflation vs deflation
— PPI and CPI
— Average inflation rate vs general inflation rate
— Actual dollars vs constant dollars

— Equivalence calculation under inflation

— Inflation free interest rate vs market interest rate
— Constant dollar analysis and actual dollar analysis

— Effects of inflation on project cash flows

What is Inflation? — Time Value of Money
qEarning Power
Definition: Inflation is qPurchasing Power
the rate at which the
general level of prices q Earning Power
and goods and
services is rising, and qInvestment Opportunity
subsequently,
q Purchasing Power
purchasing power is
falling. qDecrease in purchasing power
(inflation)
qIncrease in purchasing power
(deflation)
Inflation - Decrease in Purchasing Power
$100 $100

1990 1990 2010

You could buy 50 Big Macs You can only buy 28.5 Big
in year 1990 with $100 Macs in year 2010.

$2.00 / unit 75%

$3.50 / unit
Price change
due to
inflation

The $100 in year 2010 has only $57

worth purchasing power of 1990
Deflation - Increase in Purchasing Power
$100 $100

2004 2005 2006 2010 2004 2005 2006 2010

You could purchase You can now purchase

63.69 gallons of purified 80 gallons of purified
drink water a year ago. drink water.

20.38%
$1.57 / gallon $1.25 / gallon
Price change due to
deflation
Source: www.tradingeconomics.com
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 average rate that accounts
for the effect of varying 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
Consumer Price Index — CPI (Old measure) – Base Period = 1967
(CPI): the CPI compares the — 1967 100
cost of a sample “market
— 2010 649.10 (January)
basket” of goods and
services in a specific period
relative to the cost of the
same “market basket” in — CPI (New measure) – Base Period
an earlier reference period.
(2006)
This reference period
designated as the base — 2006 100
period. — 2017 147.8 (March 2017)
Source: http://www.census.gov.ph/business/price-indices
Average Inflation Rate (f )
Fact:
qBase Price = $100 (year 0)
qInflation rate (year 1) = 4%
qInflation rate (year 2) = 8%
Find: 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 following equivalence
equation.
$100 ( 1+ f)2 = $112.32
f = 5.98%
$112.32

0 1
2
$100
Example: Average Inflation Rate
Sample Calculation for
Average Inflation rate for — Average Inflation Rate
Gasoline:

Given: P = 127.3, F = 175.3,

N = 2009-2000 = 9

Find: f
 Example: Yearly and Average Inflation Rates
q Year cost data:

Year Cost
— Solution:
0 $504,000

1 538,400

2 577,000

3 629,500

q Find: Yearly and Average

inflation rates
Inflation Terminology – II
— Actual Dollars (Ak ): Estimates of future cash
flows for year k that take into account any
anticipated future changes in amount caused by
inflationary or deflationary effects.
— Real Dollars (Rk / A’k ): Estimates of future cash
flows for year k in constant purchasing power,
independent of the passage of time (or base
period) (also constant dollars).
Finding Actual Dollars
— Conversion from Real to Actual — General inflation rate = 5%
Dollars
Period Net Cash
Period
Flow in
Net Cash
Conversion
Flow in Cash
Conversion
Flow in Cash
Constant $ Constant
Factor$ Actual
Factor$ Ac
0 -$250,000
0 (1+0.05)0
-$250,000 (1+0.05)0
-$250,000 -$

1 1 100,000 100,0001
(1+0.05) 105,0001
(1+0.05)

2 2 110,000 110,0002
(1+0.05) 121,2752
(1+0.05)

3 3 120,000 120,0003
(1+0.05) 138,9153
(1+0.05)

4 4 130,000 130,0004
(1+0.05) 158,0164
(1+0.05)

5 5 120,000 120,0005
(1+0.05) 153,1545
(1+0.05)
Finding Real Dollars
— Conversion from Actual to Real — General inflation rate of 5%
dollars

End of Cash Flow in Conversion Cash Flow in Loss in

period 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

Inflation Terminology - III
— Real interest rate - (ir): an estimate of the true earning
power of money when the inflation effects have been
removed.
— Market interest rate (ic): an 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).
Equivalence Calculations under Inflation

Types of Interest Rate

Combined (Market) Interest
Real Interest Rate (ir)
Rate (ic)

Types of Cash Flows

Estimated in Real Dollars Estimated in Actual Dollars

Types of Analysis Method

Real-Dollar Analysis Actual-Dollar Analysis
Inflation and Cash Flow Analysis
qReal Dollar analysis

q Estimate all future cash flows in real dollars.

q Use ir as an interest rate to find the equivalent worth.

qActual Dollar Analysis

q Estimate all future cash flows in actual dollars.

q Use ic as an interest rate to find the equivalent worth.
Common mistakes
— ic and Rk - bias against capital investment
— ir and Ak – bias towards capital investment
When do we Prefer Real Dollar Analysis?

— In the absence of inflation, all economic analyses up

to this point is, in fact, the real dollar analysis.
— Real dollar analysis is common in the evaluation of
many long-term public projects, because
governments do not pay income taxes.
— For private sector, income taxes are levied based on
the taxable income in actual dollars, so the actual
dollar analysis is more common.
Two Alternate Ways in Cash Flow 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.

Example: Deflation Method
Step 1: Converting Actual Dollars into
Constant Dollars, f = 5% and MARR = Step 2: Calculating Equivalent
10% Present Worth, using ir
Graphical Overview on Deflation Method (Example 11.6):
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

Real -$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
Adjusted-Discount Method – Perform Deflation and
Discounting in One Step

o Discrete Compounding

ic = ir + f + ir f
An Step 1

(1+ f )n
Pn =
(1+ ir )n
Step 2
 Example: Adjusted-Discounted Method

Given: inflation-free
n Cash Flows in Actual Multiplied Equivalent
interest rate = 0.10, general Dollars by Present Worth
inflation rate = 5%, and 0 -$75,000 1 -$75,000
cash flows in actual dollars 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
Find: ic and PW
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 = iʹ + f + iʹf = 15.5%

Present $28,218
-$75,000
Worth $16,295
$26,761 $21,288
$27,706
$45,268
Rate of Return Analysis under Inflation
_
f = 10%
— Principle: True (real) rate of
return should be based on n Ak Rk
constant dollars.
0 -$30,000 -$30,000
— If the rate of return is
1 13,570 12,336
computed based on cash flows
2 15,860 13,108
in actual dollars, the real rate
of return can be calculated as: 3 13,358 10,036
4 13,626 9,307

1 + IRR A IRR 31.34% 19.40%

IRRR = _
−1
1+ f
Decision Criterion
— If you use 31.34% as your IRR, you should use a market
interest rate (or inflation-adjusted MARR) to make an
accept and reject decision.
— If you use 19.40% as your IRR, you should use an
inflation-free interest rate (inflation-free MARR) to make
an accept and reject decision. In our example, MARR =
20%.
Seatwork