Engr 360 Engineering Econ. 14.1 Inflation Effects Monetary inflation occurs when money loses its pur

1


Engr 360 Engineering Econ.
14.1Inflation Effects Monetary inflation
occurs when money loses its purchasing power over
time. That is, when commodity or service prices
inflate we can buy less with the same amount of
money (the purchasing power of our dollars is
decreasing). Typical causes of inflation1. A
surplus of money supply in the market (as
controlled by the Federal Reserve) tends to
cause the value of dollars to decrease.2.
Exchange rates with foreign currency reflect the
strength of the dollar in world markets (as the
dollar weakens, prices of foreign goods will
increase).3. Increased operating costs of
producers or increased demand from consumers will
increase prices.
2


Engr 360 Engineering Econ.
14.2Definitions Actual dollars The
physical money we carry around and spend (that
is, spendable cash or money on deposit in banks).
These dollars sometimes are called inflated
dollars because they include any inflation
that has reduced their purchasing power. Real
dollars Dollars tied to some constant-purchasing
-power base year and having a value that does
not change with time (e.g., 1990-based
dollars). These dollars sometimes are called
constant dollars or inflation-free dollars
because they do not carry any effects of
inflation. Inflation rate (f) the annual
rate of increase () in the amount of dollars
needed to purchase the same amount of goods.
3


Engr 360 Engineering Econ.
14.3 Definitions (contin.) Market interest
rate (i) the common rate of interest in the
marketplace (i.e., banks, lenders, investment
returns, etc.) it is a combined interest rate
because it includes the effects of both
real-money growth and inflation. Real interest
rate (i) the interest rate that measures the
real growth of money over time, without
including the effects of inflation it
sometimes is called the inflation-free interest
rate. Important relationships i i
f (i)(f) i (i f) /
(1 f) f (i
i) / (1 i)
4


Engr 360 Engineering Econ.
14.4 Economic Analysis Procedures When
dealing with actual dollars, we need to use the
market interest rate (i) for all compounding
and discounting calculations. When dealing
with real dollars, we need to use the real
interest rate (i) for all compounding and
discounting calculations. Actual and real
dollars are related by the inflation rate over
any given specified time span.Example What
is a 1000 investment made in 1980 really worth
in 2005 if the annual market interest rate during
that period was 8 and the average annual
inflation rate was 3? i
(.08-.03)/(1.03) .04854 or 4.854 Actual
dollars in 2005 A1980F/P,8,25
1000(6.848) 6848 Real 1980-dollars in 2005
R1980F/P,4.854,25 1000(3.2706) 3271
OR 6848P/F,3,25 6848(.4776) 3271
5


Engr 360 Engineering Econ.
14.5 Example Our small manufacturing firm is
negotiating a 5-yr electricity contract with the
local power utility. The contract involves a
flat rate of 80,000 in the first year, then 5
annual increases thereafter. If our corporate
MARR is 12 and the anticipated annual inflation
rate is 2, what is the NPW of this contract?
Yr. Then-Current Cost
Real-Dollar Cost (today) 1
80,000 80,000P/F,2,1
80,000(.9804) 78,432 2 80,000(1.05)
84,000 84,000(.9612) 80,741 3
80,000(1.05)2 88,200 88,200(.9423)
83,111 4 80,000(1.05)3 92,610
92,610(.9238) 85,553 5 80,000(1.05)4
97,241 97,241(.9057) 88,071 i
(.12-.02)/(1.02) .098 or 9.8NPW
-78,432(1.098)-1 - 80,741(1.098)-2 -
83,111(1.098)-3 - 85,553(1.098)-4 -
88,071(1.098)-5 -315,233 (based on R)
.8929NPW
-80,000P/F,12,1 - 84,000(.7972) -
88,200(.7118) - 92,610(.6355) -
97,241(.5674) -315,206 (based on A same
answer, rnd-off err.)
6


Engr 360 Engineering Econ.
14.6Price Indexes Price indexes describe
the relative price change of goods and
services referenced to a base year where the
price index is set to a reference value of
100. We can use published lists of price
(cost) indexes to compute the year-to-year
percentage increase in price for a given
commodity (that is, its inflation rate)
Inflation for 2004 100 x (CI2004 CI2003) /
CI2003 For example f2004 100 x (558
544) / 544 2.57 The average rate of
increase over a number of years is a F/P
factor problem using the beginning and ending
cost indexes Avg. inflation
1994-2004 is the i for CI2004 CI1994 (1i)10
For example f94-04 (558/420)1/10 1
0.0288 or 2.88
7


Engr 360 Engineering Econ.
14.7Composite cost indexes track groups or
bundles of related types of commodities or
services, rather than individual ones. Two of
the most often used composite indexes in the U.S.
are 1. Consumer Price Index (CPI) consists
of common consumer expenses such as housing,
food, transportation, entertainment. This
serves as a reasonable inflation indicator in
regard to price- change impact on consumers.
2. Producer Price Index (PPI) consists of
common producer expenses such as raw
materials, labor costs, energy costs, etc.Use
of historical average increases (or decreases) in
specific or composite cost indexes can help us
predict future changes that should be included in
our engineering econ analyses. If different
items are inflating at different rates we can
predict their values in future years using actual
dollars, then apply a market interest rate to
discount the cash flows. See Example 14-6 in
text.
8


Engr 360 Engineering Econ.
14.8 Example The compression testing machine
in our lab is due for some overhaul work if we
want to keep it operating efficiently for 10 more
years. We are considering two options 1. Do a
partial overhaul now (3200) and another partial
overhaul at 5 years (3200) 2. Do a complete
overhaul now (6000) that will last for the
entire 10 years. The cost index for overhaul
work on this machine 4 yr. ago was 254, and
currently is 309. MARR is 7. A) Using the CI
history, what is the est. inflation rate for this
overhaul service? f (309/254)1/4 1
0.0502 5.0 B) Which option is preferred if we
ignore inflation? If we include inflation?
Ignore inflaiton .7130 NPW1
-3200 - 3200P/F,7,5 -5482 gt -6000
--- Choose 1 Incl. inflation NPW1
-3200 - 3200(1.05)5P/F,7,5 -6112 lt -6000
--- Chose 2Note This demonstrates the
advantage of expenditures up front in an
inflationary environment.
9


Engr 360 Engineering Econ.
14.9Inflation and After-Tax Analysis In
the before-tax situation, future annual benefits
are affected by inflation in a constant
proportional way (i.e., annual benefits are
inflated at the same rate, so they continue to be
equivalent in terms of Year-0 dollars).
Thus, whether we consider inflation or not,
the BTCFs will have the same IRR and the same
NPW. No special adjustments are needed in
before- tax analysis when future benefits
respond to inflation (or to deflation).
However, in after-tax analysis the inflation will
result in lower IRRs and NPWs, because the
depreciation allowances are independent of
inflation, resulting in larger amounts of taxable
income (and subsequent larger income tax
payments). In other words, even though the
ATCF in actual dollars increases, the extra
amount is not high enough to offset both
inflation and increased income taxes.
10


Engr 360 Engineering Econ.
14.10 Example Consider a MACRS 3-yr asset
with a capital cost of 8000 and regular annual
benefits of 2500 (with no salvage value). MARR
is 6. Use 0 4 infla. Year-0
MACRS-3 Taxable Tax _at_ Actual
Yr. BTCF Deprec. Income -35
ATCF (no inflation) 0 -8000

-8000 1 2500 2666 -166
58 2558 2
2500 3556 -1056 370
2870 3 2500 1185 1315
-460 2040 4 2500
593 1907 -667 1833
Before-Tax IRR 9.56 NPW663 After-Tax
IRR 6.77 NPW132 4 Infla.
MACRS-3 Taxable Tax _at_ Actual
Year-0 Yr. BTCF Deprec.
Income -35 ATCF(4 infla.) ATCF 0
-8000
-8000 -8000 1
2600 2666 -66 23
2623 x(1.04)-1 2522
2 2704 3556 -852
298 3002 x(1.04)-2 2776 3
2812 1185 1627 -569
2243 x(1.04)-3 1994 4 2925
593 2332 -816 2109
x(1.04)-4 1803
After-Tax IRR
5.72 NPW -48 Thus, it is not a desirable
investment when inflation is considered.