INFLATION

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INFLATION

• Prices of all goods and services change over time
• An increase in average prices over time is called
  inflation
• A decrease in average prices over time is called
  deflation
• Prices are likely to change over the life of an
  engineering project due to inflation or deflation

2
NOMINAL AND REAL DOLLARS

• Nominal Dollars dollars at the time that cash
  flows occur
• These are the ones in our pockets, and recorded
  in our bank books, cheque books, accounting
  records
• The purchasing power of these changes due to
  inflation/deflation
• Also as known as current or actual dollars
• Real Dollars dollars of constant purchasing
  power
• These are a hypothetical unit of measure
• Always need a reference date (usually called the
  base year)
• The base year need not be the current year
• Also as known as constant dollars

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USES OF PRICE INDICES IN ENGINEERING PROJECTS

• Contract Escalation
• A mining company entering a long-term equipment
  purchase contract with a major distributor wants
  to establish guidelines which will govern the
  future prices of the equipment it buys.
• Using the Mining, Quarrying and Ore dressing
  Machinery Index, the company ties the future
  price increases of equipment to those of the
  index.
• Tracking Selling Prices
• A pharmaceutical firm wants to compare price
  changes for its products with those of the
  industry as a whole.
• Using a series of Pharmaceutical Indexes,
  analysts can compare their price trends over time
  with those of the industry. In this way, they can
  get a sense of their own competitiveness.

4
CONVERSION BETWEEN ACTUAL AND REAL DOLLARS

• If we have an estimate of the inflation rate per
  period over N periods, we can convert actual
  dollars in period N to real dollars.
• AN actual dollars in year N
• R0,N real dollars equivalent to AN relative to
  year 0 (the base year)
• f the inflation rate per year (assumed to be
  constant from year 0 to year N)

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• Then the conversion from actual dollars in year N
  to real dollars in year N relative to the base
  year 0 is
• The base year (0) is usually omitted from the
  notation
• This can conveniently be written and computed
  with the Present Worth Factor
• RN AN(P/F, f, N)
• RN is real dollars at time N and not a present
  worth

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NOMINAL AND REAL INTEREST RATES

• The real interest rate, i, is the interest rate
  that would yield the same number of real dollars
  in the absence of inflation as the actual
  interest rate yields in the presence of
  inflation.
• From nominal to real
• From real to actual
• i i f if

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ACTUAL AND REAL MARRS

• If investors expect inflation, they will require
  higher actual rates of return on their
  investments than if no inflation was expected.
• MARRactual MARRreal f MARRreal f

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ECONOMIC EVALUATION WITH INFLATION

• Method 1 Work with real cash flows and find the
  real MARR using an estimate of f.
• Method 2 Adjust the real cash flows for
  inflation ie., get estimates of the actual cash
  flows using f, and apply the actual MARR.