Contemporary Engineering Economics, 4 th edition, © 2007 Effects of Inflation on Project Cash Flows...

Contemporary Engineering Economics, 4th edition, © 2007

Effects of Inflation on Project Cash Flows

Lecture No. 45Chapter 11Contemporary Engineering EconomicsCopyright © 2006


Effects of Inflation on Projects with Depreciable Assets

Item Effects of Inflation

Depreciation expense

Salvage value

Depreciation expense is charged to taxable income in dollars of declining values; taxable income is overstated, resulting in higher taxes

Inflated salvage value combined with book values based on historical costs results in higher taxable gains.

Note: Depreciation expenses are based on historical costs andalways expressed in actual dollars


Example 11.8

Reconsider the Automated Machining Center project discussed earlier. What will happen to this investment project if the general inflation during the next five years is expected

to increase by 5% annually, sales, operating costs, and working capital requirements

are assumed to increase accordingly, depreciation will remain unchanged, but taxes, profits, and

thus cash flow will be higher. the firm’s inflation-free interest rate is known to be 15%.

Determine the PW of the project.


Example 11.8 Excel Worksheet

Depreciation deductiondoes not increase overtime to keep pace withinflation.

NPW = $38,899 > 0



Loan repayments

Borrowers repay historical loan amounts with dollars of decreased purchasing power, reducing the debt-financing cost.

Effects of Borrowed Funds under Inflation


Example 11.10 Effects of Inflation on Payments with Financing

Inflation Rate 0 1 2 3 4 5

Income Statement

Revenues 5% $105,000 $110,250 $115,763 $121,551 $127,628 Expenses: Labor 5% $ 21,000 $ 22,050 $ 23,153 $ 24,310 $ 25,526 Material 5% $ 12,600 $ 13,230 $ 13,892 $ 14,586 $ 15,315 Overhead 5% $ 8,400 $ 8,820 $ 9,261 $ 9,724 $ 10,210 Depreciation $ 17,863 $ 30,613 $ 21,863 $ 15,613 $ 5,581 Debt interest 9,688 8,265 6,622 4,724 2,532

Taxable income $ 35,449 $ 27,272 $ 40,973 $ 52,593 $ 68,464 Income Taxes (40%) 14,180 10,909 16,389 21,037 27,386

Net Income $ 21,269 $ 16,363 $ 24,584 $ 31,556 $ 41,078

Cash Flow Statement

Operating activities: Net income 21,269 16,363 24,584 31,556 41,078 Depreciation $ 17,863 $ 30,613 $ 21,863 $ 15,613 $ 5,581 Investment activities: Investment (125,000)

Salvage 5% 63,814 Gains tax (12,139) Financing activities Borrowed funds 62,500 Princial repayment (9,179) (10,601) (12,244) (14,142) (16,334)

Net Cash Flow $ (62,500) $ 29,953 $ 36,375 $ 34,203 $ 33,027 $ 82,000 (in actual dollars) Net Cash Flow 5% $ (62,500) $28,527 $32,993 $29,545 $27,171 $64,249 (in constant dollars) Equ. Present Worth 15% $ (62,500) $24,806 $24,948 $19,427 $15,535 $31,943

Net Present Worth $54,159

The debt paymentsize does notchange with inflation

63,814



Rate of Return and NPW

Unless revenues are sufficiently increased to keep pace with inflation, tax effects and/or a working capital drain result in lower rate of return or lower NPW.

Effects of Inflation on Return on Investment


Rate of return Calculation in the Absence of Inflation

IRR’ = 21.88%

The investmentis acceptable.

MARR = 20%


Rate of Return Calculation under Inflation

IRR’ = 19.40%

The investmentis no longer acceptable.

MARR = 20%


Rate of Return Analysis under Inflation Principle:True (real) rate of

return should be based on constant dollars.

If the rate of return is computed based on actual dollars, the real rate of return can be calculated as:

n

Net cash flows in actual dollars

Net cash flows in constant dollars

0

1

2

3

4

-$30,000

13,570

15,860

13,358

13,626

-$30,000

12,336

13,108

10,036

9,307

IRR 31.34% 19.40%

ii

f'

.

..40%

_

1

11

1 0 3134

1 0 101

19Not correct IRR

f_

10%


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%.



Working capital requirement

Known as working capital drain, the cost of working capital increases in an inflationary environment.

Effects of Inflation on Working Capital


Example 11.12 (a) Without Inflation


Example 11.12 (b) With Inflation


Working Capital Requirements under Inflation


Summary

The Consumer Price Index (CPI) is 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.

Inflation is the term used to describe a decline in purchasing power evidenced in an economic environment of rising prices.

Deflation is the opposite: An increase in purchasing power evidenced by falling prices.


The general inflation rate (f) is an average inflation rate based on the CPI. An annual general inflation rate ( ) can be calculated using the following equation:

Specific, individual commodities do not always reflect the general inflation rate in their price changes. We can calculate an average inflation rate for a specific commodity (j) if we have an index (that is, a record of historical costs) for that commodity.

f

fCPI CPI

CPInn n

n

1

1


Project cash flows may be stated in one of two forms

Actual dollars (An): Dollars that reflect the inflation or deflation rate.

Constant dollars (A’n): Year 0 dollars Interest rates for project evaluation may be

stated in one of two forms:Market interest rate (i): A rate which combines the effects of interest and inflation; used with actual dollar analysisInflation-free interest rate (i’): A rate from which the effects of inflation have been removed; this rate is used with constant dollar analysis


To calculate the present worth of actual dollars, we can use a two-step or a one-step process:Deflation method—two steps:1. Convert actual dollars by deflating with the general inflation rate of

2. Calculate the PW of constant dollars by discounting at i’Adjusted-discount method—one step

1. Compute the market interest rate. 2. Use the market interest rate directly to find

the present value.

f

Contemporary Engineering Economics, 4 th edition, © 2007 Effects of Inflation on Project Cash Flows...

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