Lecture No45

8/17/2019 Lecture No45

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Contemporary EngineeringEconomics, 4th edition, © 2007

Efects o Inationon Project CashFlows

Lecture No. 45

Chapter 11

Contemporary Engineering Economics

Copyright © 2006


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Efects o Ination on Projects with Depreciable Assets

Item Effects of Inflation

epreciation e!pense

"al#age #alue

epreciation e!pense is charge$ tota!a%le income in $ollars of $eclining

#alues& ta!a%le income is o#erstate$'resulting in higher ta!es

Inflate$ sal#age #alue com%ine$ (ith%oo) #alues %ase$ on historical costs

results in higher ta!a%le gains.

Note: Depreciation expenses are based on historical costs and

always expressed in actual dollars


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Example 11.8

*econsi$er the +utomate$ ,achining Center pro-ect$iscusse$ earlier. hat (ill happen to thisin#estment pro-ect if

the general inflation $uring the ne!t fi#e years is e!pecte$to increase %y 5/ annually' sales' operating costs' an$ (or)ing capital reuirements

are assume$ to increase accor$ingly' $epreciation (ill remain unchange$' %ut ta!es' profits' an$

thus cash flo( (ill %e higher. the firms inflationfree interest rate is )no(n to %e 15/.

etermine the 3 of the pro-ect.


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Example 11.8 Excel

or!sheet

epreciation $e$uction$oes not increase o#er time to )eep pace (ithinflation.

N3 7'788 9 0


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Loan

repayments

:orro(ers repay historical

loan amounts (ith $ollars of$ecrease$ purchasing po(er're$ucing the $e%tfinancingcost.

Efects o "orrowe# F$n#s$n#er Ination


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Example 11.1% Efects o Ination onPa&ments with Financin'

;he $e%t paymentsi


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*ate of *eturn

an$ N3

=nless re#enues are

sufficiently increase$ to )eeppace (ith inflation' ta! effectsan$>or a (or)ing capital $rainresult in lo(er rate of return orlo(er N3.

Efects o Ination on (et$rnon In)estment


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(ate o ret$rn Calc$lation inthe Absence o Ination

I** 21.77/

;he in#estment

is accepta%le.

,+** 20/


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(ate o (et$rn Calc$lation$n#er Ination

I** 18.40/

;he in#estment

is no longeraccepta%le.

,+** 20/


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(ate o (et$rn Anal&sis $n#erInation 3rinciple?;rue @realA rate of

return shoul$ %e %ase$ onconstant $ollars.

If the rate of return is

compute$ %ase$ on actual$ollars' the real rate ofreturn can %e calculate$ as?

n

Net cashflo(s inactual$ollars

Net cashflo(s inconstant$ollars

01

2

4

0'0001'5B0

15'760

1'57

1'626

0'00012'6

1'107

10'06

8'0B

IRR 31.34% 19.40%i

i

'

.

.

.40%

_ =

+

+

−

=+

+

−

=

1

11

1 0 3134

1 0 101

19 Not correct IRR

_

= 10%


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Decision Criterion

If you use 1.4/ as your I**' you shoul$use a mar)et interest rate @or inflationa$-uste$ ,+**A to ma)e an accept an$

re-ect $ecision. If you use 18.40/ as your I**' you shoul$

use an inflationfree interest rate @inflation

free ,+**A to ma)e an accept an$ re-ect$ecision. In our e!ample' ,+** 20/.


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or)ing capital

reuirement

no(n as (or)ing capital

$rain' the cost of (or)ingcapital increases in aninflationary en#ironment.

Efects o Ination on or!in' Capital


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Example 11.1* +a, itho$tInation


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Example 11.1* +b, ithInation


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or!in' Capital(e-$irements $n#er

Ination


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$mmar&

;he Consumer Price Index (CPI) is a statisticalmeasure of change' o#er time' of the prices ofgoo$s an$ ser#ices in ma-or e!pen$iture groupsDsuch as foo$' housing' apparel' transportation'

an$ me$ical careDtypically purchase$ %y ur%anconsumers. Inflation is the term use$ to $escri%e a decline

in purchasing power e#i$ence$ in an economicen#ironment of rising prices.

Deflation is the opposite? +n increase inpurchasing po(er e#i$ence$ %y falling prices.


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;he general inflation rate @f A is an a#erageinflation rate %ase$ on the C3I. +n annual

general inflation rate @ A can %e calculate$ usingthe follo(ing euation?

"pecific' in$i#i$ual commo$ities $o not al(aysreflect the general inflation rate in their pricechanges. e can calculate an average inflation

rate for a specific commo$ity @ j A if (e ha#e anin$e! @that is' a recor$ of historical costsA for thatcommo$ity.

!"I !"I

!"I n

n n

n

=

−−

−

1

1


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3ro-ect cash flo(s may %e state$ in one of t(oforms

Actual dollars ( An): ollars that reflect theinflation or $eflation rate.

Constant dollars ( A’ n): ear 0 $ollars Interest rates for pro-ect e#aluation may %e

state$ in one of t(o forms?

Market interest rate (i ): + rate (hich com%inesthe effects of interest an$ inflation& use$ (ithactual dollar analysis

Inflationfree interest rate (i’ ): + rate from(hich the effects of inflation ha#e %een remo#e$&this rate is use$ (ith constant $ollar analysis


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;o calculate the present (orth of actual $ollars'

(e can use a t(ostep or a onestep process?Deflation method!two steps:

1. Con#ert actual $ollars %y $eflating (ith thegeneral inflation rate of

2. Calculate the 3 of constant $ollars %y$iscounting at i’

Ad"usteddiscount method!one step

1. Compute the mar)et interest rate.

2. =se the mar)et interest rate $irectly to fin$the present #alue.

Lecture No45

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