Engr 360 Engineering Econ. 14.

Inflation 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 inflation:

1. 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.
 Engr 360 Engineering Econ. 14.2

Definitions

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.

 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’)
 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 = $A1980[F/P,8%,25] = $1000(6.848) = $6848
Real 1980-dollars in 2005= $R1980[F/P,4.854%,25]= $1000(3.2706)= $3271
OR = $6848[P/F,3%,25] = $6848(.4776) = $3271
 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
2 80,000(1.05)= 84,000
3 80,000(1.05)2= 88,200
4 80,000(1.05)3= 92,610
5 80,000(1.05)4= 97,241
$80,000[P/F,2%,1]= 80,000(.9804)= $78,432
84,000(.9612) = 80,741
88,200(.9423) = 83,111
92,610(.9238) = 85,553
97,241(.9057) = 88,071

i’ = (.12-.02)/(1.02) = .098 or 9.8%

NPW = -$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)
.8929
NPW = -$80,000[P/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.)
Price 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 (1+i)10

For example: f94-04 = (558/420)1/10 – 1 = 0.0288 or 2.88%
 Engr 360 Engineering Econ. 14.7

Composite 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.
 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 - 3200[P/F,7%,5] = -$5482 > -$6000 --- Choose 1

Incl. inflation:
NPW1 = -$3200 - 3200(1.05)5[P/F,7%,5] = -$6112 < -$6000 --- Chose 2

Note: This demonstrates the advantage of expenditures up front in an

inflationary environment.
 Engr 360 Engineering Econ. 14.9

Inflation 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 BTCF’s 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
IRR’s and NPW’s, 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.
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 @ $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% NPW=$663 After-Tax IRR: 6.77% NPW=$132

4% Infla. MACRS-3 Taxable Tax @ $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