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Chapter 14: Inflation and Price Change

14-1
During times of inflation, the purchasing power of a monetary unit is reduced. In this way the
currency itself is less valuable on a per unit basis. In the USA, what this means is that during
inflationary times our dollars have less purchasing power, and thus we can purchase less
products, goods and services with the same $1, $10, or $100 dollar bill as we did in the
past.

14-2
Actual dollars are the cash dollars that we use to make transactions in our economy. These
are the dollars that we carry around in our wallets and purses, and have in our savings
accounts. Real dollars represent dollars that do not carry with them the effects of inflation,
these are sometimes called “inflation free” dollars. Real dollars are expressed as of
purchasing power base, such as Year-2000-based-dollars.

The inflation rate captures the loss in purchasing power of money in a percentage rate form.
The real interest rate captures the growth of purchasing power, it does not include the
effects of inflation is sometimes called the “inflation free” interest rate. The market interest
rate, also called the combined rate, combines the inflation and real rates into a single rate.

14-3
There are a number of mechanisms that cause prices to rise. In the chapter the authors talk
about how money supply, exchange rates, cost-push, and demand pull effects can
contribute to inflation.

14-4
Yes. Dollars, and interest rates, are used in engineering economic analyses to evaluate
projects. As such, the purchasing power of dollars, and the effects of inflation on interest
rates, are important.

The important principle in considering effects of inflation is not to mix-and-match dollars and
interest rates that include, or do not include, the effect of inflation. A constant dollar analysis
uses real dollars and a real interest rate, a then-current (or actual) dollar analysis uses
actual dollars and a market interest rate. In much of this book actual dollars (cash flows) are
used along with a market interest rate to evaluate projects  this is an example of the later
type of analysis.

14-5
The Consumer Price Index (CPI) is a composite price index that is managed by the US
Department of Labor Statistics. It measures the historical cost of a bundle of “consumer
goods” over time. The goods included in this index are those commonly purchased by
consumers in the US economy (e.g. food, clothing, entertainment, housing, etc.).
Composite indexes measure a collection of items that are related. The CPI and Producers
Price Index (PPI) are examples of composite indexes. The PPI measures the cost to
produce goods and services by companies in our economy (items in the PPI include
materials, wages, overhead, etc.). Commodity specific indexes track the costs of specific
and individual items, such as a labor cost index, a material cost index, a “football ticket”
index, etc.

Both commodity specific and composite indexes can be used in engineering economic
analyses. Their use depends on how the index is being used to measure (or predict) cash
flows. If, in the analysis, we are interested in estimating the labor costs of a new production
process, we would use a specific labor cost commodity index to develop the estimate. Much
along the same lines, if we wanted to know the cost of treated lumber 5 years from today,
we might use a commodity index that tracks costs of treated lumber. In the absence of
commodity indexes, or in cases where we are more interested in capturing aggregate
effects of inflation (such as with the CPI or PPI) one would use a composite index to
incorporate/estimate how purchasing power is affected.

14-6
The stable price assumption is really the same as analyzing a problem in Year 0 dollars,
where all the costs and benefits change at the same rate. Allowable depreciation charges
are based on the original equipment cost and do not increase. Thus the stable price
assumption may be suitable in some before-tax computations, but is not satisfactory where
depreciation affects the income tax computations.

14-7
F = P (F/P, f%, 10 yrs) = $10 (F/P, 7%, 10) = $10 (1.967) = $19.67

14-8
iequivalent = i’inflation corrected + f% + (i'inflation corrected) (f%)

In this problem: iequivalent = 5%


f% = +2%
iinflation corrected = unknown

0.05 = i’inflation corrected + 0.02 + (i'inflation corrected) (0.02)

i'inflation corrected = (0.05 – 0.02)/(1 + 0.02) = 0.02941 = 2.941%

That this is correct may be proved by the year-by-year computations.

Year Cash Flow (1 + f)-n Cash Flow in PW at 2.941%


(P/F, f%, n) Year 0 dollars
0 -$1,000 0 -$1,000.00 -$1,000.00
1 +$50 0.9804 +$49.02 +$47.62
2 +$50 0.9612 +$48.06 +$45.35
3 +$50 0.9423 +$47.12 +$43.20
4 +$50 0.9238 +$46.19 +$41.13
5 +$50 0.9057 +$45.29 +$39.18
6 +$50 0.8880 +$44.40 +$37.31
7 +$50 0.8706 +$43.53 +$35.54
8 +$50 0.8535 +$42.68 +$33.85
9 +$50 0.8368 +$41.84 +$32.23
10 +$50 0.8203 +$41.02 +$30.70
11 +$50 0.8043 +$40.22 +$29.24
12 +$50 0.7885 +$39.43 +$27.85
13 +$50 0.7730 +$38.65 +$26.52
14 +$50 0.7579 +$37.90 +$25.26
15 +$50 0.7430 +$37.15 +$24.05
16 +$50 0.7284 +$36.42 +$22.90
17 +$50 0.7142 +$35.71 +$21.82
18 +$50 0.7002 +$35.01 +$20.78
19 +$50 0.6864 +$34.32 +$19.79
20 +$1,000 0.6730 +$706.65 +$395.76
+$0.08
Therefore, iinflation corrected = 2.94%.

14-9
$20,000 in Year 0 dollars

n = 14 yrs

P = Lump Sum
deposit
Actual Dollars 14 years hence = $20,000 (1 + f%)n
= $20,000 (1 + 0.08)14
= $58,744

At 5% interest:

P = F (1 + i)-n = $58,744 (1 + 0.05)-14 = $29,670

Since the inflation rate (8%) exceeds the interest rate (5%), the money is annual losing
purchasing power.

Deposit $29,670.

14-10
To buy $1 worth of goods today will require:
F = P (F/P, f%, n) n years hence.
F = $1 (1 + 0.05)5 = $1.47 5 years hence.
For the subsequent 5 years the amount required will increase to:
$1.47 (F/P, f%, n) = $1.47 (1 + 0.06)5 = $1.97

Thus for the ten year period $1 must be increased to $1.97. The average price change per
year is:
($1.97 - $1.00)/10 yrs = 9.7% per year

14-11
(1 + f)5 = 1.50
(1 + f) = 1.501/5 = 1.0845
f = 0.845 = 8.45%

14-12
Number of dollars required five years hence to have the buying power of one dollar today =
$1 (F/P, 7%, 5) = $1.403

Number of cruzados required five years hence to have the buying power of 15 cruzados
today = 15 (F/P, 25%, 5) = 45.78 cruzados.

Combining: $1.403 = 45.78 cruzados


$1 = 32.6 cruzados (Brazil uses cruzados.)

14-13
Price increase = (1 + 0.12)8 = 2.476 x present price
Therefore, required fuel rating = 10 x 2.476 = 24.76 km/liter

14-14
P= 1.00 F = 1.80 n = 10 f=?

1.80 = 1.00 (F/P, f%, 10)


(F/P, f%, 10) = 1.80

From tables, f is slightly greater than 6%. (f = 6.05% exactly).

14-15
i = i' + f + (i') (f)
0.15 = i' + 0.12 + 0.12 (i')
1.12 i' = 0.03
i' = 0.03/1.12 = 0.027 = 2.7%
14-16
Compute equivalent interest/3 mo. =x

ieff = (1 + x)n – 1
0.1925 = (1 + x)4 – 1
(1 + x) = 1.19250.25 = 1.045
x = 0.045 = 4.5%/3 mo.

$3.00

n=?
i = 4.5%

$2.50

$2.50 = $3.00 (P/F, 4.5%, n)


(P/F, 4.5%, n) = $2.50/$3.00 = 0.833

n is slightly greater than 4.

So purchase pads of paper- one for immediate use plus 4 extra pads.

14-17
f = 0.06
i' = 0.10
i = 0.10 + 0.06 + (0.10) (0.06) = 16.6%

14-18
(a)
$109.6
1981
1986
n=5

$90.9

$109.6 = $90.9 (F/P, f%, 5)


(F/P, f%, 5) = $109.6/$90.9 = 1.2057
f% = 3.81%
(b)
CPI

1996
n=9

f = 3.81%
$113.6

CPI1996 = $113.6 (F/P, 3.81%, 9)


= $113.6 (1 + 0.0381)9 = $159.0

14-19
F = $20,000 (F/P, 4%, 10) = $29,600

14-20
Compute an equivalent i:

iequivalent = i' + f + (i') (f)


= 0.05 + 0.06 + (0.05) (0.06)
= 0.113
= 11.3%

Compute the PW of Benefits of the annuity:


PW of Benefits = $2,500 (P/A, 11.3%, 10)
= $2,500 [((1.113)10 – 1)/(0.113 (1.113)10)]
= $14,540

Since the cost is $15,000, the benefits are less than the cost computed at a 5% real rate of
return. Thus the actual real rate of return is less than 5% and the annuity should not be
purchased.

14-21
1 = 0.20 (1.06)n
log (1/0.20) = n log (1.06)

n = 27.62 years

14-22
Use $97,000 (1 + f%)n, where f%=7% and n=15

$97,000 (1 + 0.07)15 = $97,000 (F/P, 7%, 15)


= $97,000 (2.759)
= $268,000
If there is 7% inflation per year, a $97,000 house today is equivalent to $268,000 15 years
hence. But will one have “profited” from the inflation?

Whether one will profit from owning the house depends somewhat on an examination of
the alternate use of the money. Only the differences between alternatives are relevant. If
the alterate is a 5% savings account, neglecting income taxes, the profit from owning the
house, rather than the savings account, would be: $268,000 - $97,000 (F/P, 5%, 15)
= $66,300.

On the other hand, compared to an alternative investment at 7%, the profit is $0. And if
the alternative investment is at 9% there is a loss. If “profit” means an enrichment, or being
better off, then multiplying the price of everything does no enrich one in real terms.

14-23
Let x = selling price
Then long-term capital gain = x- $18,000
Tax = 0.15 (x - $18,000)
After-Tax cash flow in year 10 = x – 0.15 (x - $18,000) = 0.85x + $2,700

Year ATCF Multiply by Year 0 $ ATCF


0 -$18,000 1 -$18,000
10 +0.85x + $2,700 1.06-10 0.4743x + $1,508

For a 10% rate of return:


$18,000 = (0.4746x + $1,508) (P/F, 10%, 10)
= 0.1830 x + $581
x = $95,186

Alternate Solution using an equivalent interest rate


iequiv = i' + f + (i') (f) = 0.10 + 0.06 + (0.10) (0.06) = 0.166

So $18,000 (1 + 0.166)10 = 0.85x + $2,700


$83,610 = 0.85x + $2,700

Selling price of the lot =x = ($83,610 - $2,700)/0.85 = $95,188

14-24
Cash Flow:
Year $500 Kit $900 Kit
0 -$500 -$900
5 -$500 $0

(a) PW$500 kit = $500 + $500 (P/F, 10%, 5) = $810


PW$900 kit = $900

To minimize PW of Cost, choose $500 kit.


(b) Replacement cost of $500 kit, five years hence
= $500 (F/P, 7%, 5) = $701.5

PW$500 kit = $500 + $701.5 (P/F, 10%, 5) = $935.60


PW$900 kit = $900

To minimize PW of Cost, choose $900 kit.

14-25
If one assumes the 5-year hence cost of the Filterco unit is:
$7,000 (F/P, 8%, 5) = $10,283
in Actual Dollars and $7,000 in Yr 0 dollars, the year 0 $ cash flows are:

Year Filterco Duro Duro – Filterco


0 -$7,000 -$10,000 -$3,000
5 -$7,000 $0 +$7,000

∆ROR = 18.5%
Therefore, buy Filterco.

14-26
Year Cost to City (Year 0 $) Benefits to City Description of Benefits
0 -$50,000
1- 10 -$5,000/yr +A Fixed annual sum in then-
current dollars
10 +$50,000 In then-current dollars

i = i' + f + i'f
= 0.03 + 0.07 + 0.03 (0.07)
= 0.1021 = 10.21%

PW of Cost = PW of Benefits
$50,000 + $5,000 (P/A, 3%, 10) = A(P/A, 10.21%, 10)
+$50,000 (P/F,10.21%,10)
$50,000 + $5,000 (8.530) = A (6.0895*) + $50,000 (0.3783*)
$92,650 = 6.0895A + $18,915

A = ($92,650 - $18,915)/6.0895
= $12,109

* Computed on hand calculator


14-27
Month BTCF
0 $0
1- 36 -$1,000
36 +$40,365

$1,000 (F/A, i%, 36 mo) = $40,365


(F/A, i%, 36) = 40.365

Performing linear interpolation:


(F/A, i%, 36)) i
41.153 ¾
%
39.336 ½
%

i = 0.50% + 0.25% [(40.365 – 39.336)/(41.153 – 39.336)]


= 0.6416% per month

Equivalent annual interest rate

i per year = (1 + 0.006416)12 – 1 = 0.080 = 8%

So, we know that i = 8% and f = 8%. Find i'.


i = i' + f + (i') (f)
0.08 = i' + 0.08 + (i') (0.08)
i' = 0% Thus, before-Tax Rate of Return = 0%

14-28
Actual Dollars: F= $10,000 (F/P, 10%, 15) = $41,770

Real Dollars:
Year Inflation
1- 5 3%
6- 10 5%
11- 15 8%

R$ in today’s base = $41,770 (P/F, 8%, 5) (P/F, 5%, 5) (P/F, 3%, 5)


= $18,968

Thus, the real growth in purchasing power has been:


$18,968 = $10,000 (1 + i*)15
i* = 4.36%

14-29
(a) F = $2,500 (1.10)50 = $293,477 in A$ today
(b) R$ today in (-50) purchasing power = $293,477 (P/F, 4%, 50)
= $41,296
14-30
(a) PW = $2,000 (P/A, ic, 8)
icombined = ireal + f + (ireal) (f) = 0.03 + 0.05 + (0.03) (0.05)
= 0.0815

PW = $2,000 (P/A, 8.15%, 9) = $11,428

(b) PW = $2,000 (P/A, 3%, 8) = $14,040

14-31
Find PW of each plan over the next 5-year period.

ir = (ic – f)/(1 + f) = (0.08 – 0.06)/1.06 = 1.19%

PW(A) = $50,000 (P/A, 11.5%, 5) = $236,359


PW(B) = $45,000 (P/A, 8%, 5) + $2,500 (P/G, 8%, 5) = $198,115
PW(C) = $65,000 (P/A, 1.19, 5) (P/F, 6%, 5)= $229,612

Here we choose Company A’s salary to maximize PW.

14-32
(a) R today $ in year 15 = $10,000 (P/F, ir%, 15)

ir = (0.15 – 0.08)/1.08 = 6.5%

R today $ in year 15 = $10,000 (1.065)15 = $25,718

(b) ic = 15%f = 8%
F = $10,000 (1.15)15 = $81,371

14-33
No Inflation Situation

Alternative A: PW of Cost = $6,000


Alternative B: PW of Cost = $4,500 + $2,500 (P/F, 8%, 8)
= $4,500 + $2,500 (0.5403)
= $5,851
Alternative C: PW of Cost = $2,500 + $2,500 (P/F, 8%, 4)
+ $2,500 (P/F, 8%, 8)
= $2,500 ( 1 + 0.7350 + 0.5403)
= $5,688

To minimize PW of Cost, choose Alternative C.


For f = +5% (Inflation)

Alternative A: PW of Cost = $6,000


Alternative B: PW of Cost = $4,500 + $2,500 (F/P, 5%, 8) (P/F, 8%, 8)
= $4,500 + $2,500 (1 + f%)8 (P/F, 8%, 8)
= $4,500 + $2,500 (1.477) (0.5403)
= $6,495
Alternative C: PW of Cost = $2,500 + $2,500 (F/P, 5%, 4) (P/F, 8%, 4)
+ $2,500 (F/P, 5%, 8) (P/F, 8%, 8)
= $2,500 + $2,500 (1.216) (0.7350)
+ $2,500 (1.477) (0.5403)
= $6,729

To minimize PW of Cost in year 0 dollars, choose Alternative A.

This problem illustrates the fact that the prospect of future inflation encourages current
expenditures to be able to avoid higher future expenditures.

14-34
Alternative I: Continue to Rent the Duplex Home

Compute the Present Worth of renting and utility costs in Year 0 dollars.

Assuming end-of-year payments, the Year 1 payment is:


= ($750 + $139) (12) = $7,068
The equivalent Year 0 payment in Year 0 dollars is:
$7,068 (1 + 0.05)-1 = $6,713.40

Compute an equivalent i
iequivalent = i' + f + (i') (f)
Where i' = interest rate without inflation = 15.5%
f = inflation rate = 5%
iequivalent = 0.155 + 0.05 + (0.155) (0.05)
= 0.21275
= 21.275%

PW of 10 years of rent plus utilities:


= $6,731.40 (P/A, 21.275%, 10)
= $6,731.40 [(1 + 0.21275)(10-1))/(0.21275 (1 + 0.21275)10)]
= $6,731.40 (4.9246)
= $33,149

An Alternative computation, but a lot more work:


Compute the PW of the 10 years of inflation adjusted rent plus utilities using 15.5% interest.
PWyear 0 = 12[$589 (1 + 0.155)-1 + $619 (1 + 0.155)-2 + …
+ $914 (1 + 0.155)-10]
= 12 ($2,762.44)
= $33,149
Alternative II: Buying a House

$3,750 down payment plus about $750 in closing costs for a cash requirement of $4,500.
Mortgage interest rate per month = (1+I)6 = 1.04 I = 0.656%
n = 30 years x 12 = 360 payments

Monthly Payment: A = ($75,000 - $3,750) (A/P, 0.656%, 360)


= $71,250 [(0.00656 (1.00656)360)/((1.00656)360 – 1)]
= -$516.36

Mortgage Balance After the 10-year Comparison Period:


A’ = $523 (P/A, 0.656%, 240)
= $523 [((1.00656)240 – 1)/(0.00656 (1.00656)240)]
= $62,335

Thus:
$523 x 12 x 10 = $62,760 total payments
$71,250 - $62,504 = $8,746 principal repayments (12.28% of loan)
= $54,014 interest payments

Sale of the property at 6% appreciation per year in year 10:


F = $75,000 (1.06)10 = $134,314
Less 5% commission = -$6,716
Less mortgage balance = -$62,335
Net Income from the sale = $65,263

Assuming no capital gain tax is imposed, the Present Worth of Cost is:
PW= $4,500 [Down payment + closing costs in constant dollars]
+ $516.36 x 12 (P/A, 15.5%, 10) [actual dollar mortgage]
+ $160 x 12 (P/A, 10%, 10) [constant dollar utilities]
+ $50 x 12 (P/A, 10%, 10) [constant dollar insurance & maint.]
- $65,094 (P/F, 15.5%, 10) [actual dollar net income from sale]
PW= $4,500 + $516.36 x 12 (4.9246) + $160 x 12 (6.145)
+ $50 x 12 (6.145)- $65,263 (0.2367)
= $35,051

The PW of Cost of owning the house for 10 years = $35,051 in Year 0 dollars. Thus
$33,149 < $35,329 and so buying a house is the more attractive alternative.

14-35
Year Cost- 1 Cost- 2 Cost- 3 Cost- 4 TOTAL PW-
TOTAL
1 $4,500 $7,000 $10,000 $8,500 $30,000 $24,000
2 $4,613 $7,700 $10,650 $8,288 $31,250 $20,000
3 $4,728 $8,470 $11,342 $8,080 $32,620 $16,702
4 $4,846 $9,317 $12,079 $7,878 $34,121 $13,976
5 $4,967 $10,249 $12,865 $7,681 $35,762 $11,718
6 $5,091 $11,274 $13,701 $7,489 $37,555 $9,845
7 $5,219 $12,401 $14,591 $7,302 $39,513 $8,286
8 $5,349 $13,641 $15,540 $7,120 $41,649 $6,988
9 $5,483 $15,005 $16,550 $6,942 $43,979 $5,903
10 $5,620 $16,506 $17,626 $6,768 $46,519 $4,995

PW = -$60,000 – ($24,000 + $20,000 + $16,702 + … +$4,995)


+ $15,000 (P/F, 25%, 10)

= $180,802

14-36
(a) Unknown Quantities are calculated as follows:
% change = [($100 - $89)/$89] x 100% = 12.36%
PSI = 100 (1.04) = 104
% change = ($107 - $104)/$104 = 2.88%
% change = ($116 - $107)/$107 = 8.41%
PSI = 116 (1.0517) = 122

(b) The base year is 1993. This is the year of which the index has a value of 100.

(c)
(i) PSI (1991) = 82
PSI (1995) = 107
h = 4 years
i* =?
i* = (107/82)0.25 – 1 = 6.88%

(ii) PSI (1992) = 89


PSI (1998) = 132
n = 6 years
i* =?
i* = (132/89)(1/6) – 1 = 6.79%

14-37
(a) LCI(-1970) = 100
LCI(-1979) = 250
n =9
i* =?
i* = (250/100)(1/9) – 1 = 10.7%
(b) LCI(1980) = 250
LCI(1989) = 417
n =9
i* =?
i* = (417/250)(1/9) – 1 = 5.85%

(c) LCI(1990) = 417


LCI(1998) = 550
n =8
i* =?
i* = (550/417)(1/8) – 1 = 3.12%
14-38
(a) Overall LCI change = [(250 – 100)/100] x 100% = 150%
(b) Overall LCI change = [(415 – 250)/250] x 100% = 66.8%
(c) Overall LCI change = [(650 – 417)/417] x 100% = 31.9%

14-39
(a) CPI (1978) = 43.6
CPI (1982) = 65.3
n =4
i* =?
i* = (65.3/43.6)(1/4) – 1 = 9.8%

(b) CPI (1980) = 52.4


CPI (1989) = 89.0
n =9
i* =?
i* = (89.0/52.4)(1/9) – 1 = 6.1%

(c) CPI (1985) = 75.0


CPI (1997) = 107.6
n = 12
i* =?
i* = (107.6/75.0)(1/12) – 1 = 3.1%

14-40
(a)
Year Brick Cost CBI
1970 2.10 442
1998 X 618

x/2.10 = 618/442
x = $2.94

Total Material Cost = 800 x $2.94 = $2,350


(b) Here we need f% of brick cost
CBI(1970) = 442
CBI(1998) = 618
n = 18
i* =?
i* = (618/442)(1/18) – 1 = 1.9%

We assume the past average inflation rate continues for 10 more years.

Brick Unit Cost in 2008 = 2.94 (F/P, 1.9%, 10)= $3.54


Total Material Cost = 800 x $3.54 = $2.833

14-41
EAT(today) = $330 (F/P, 12$, 10) = $1,025

14-42
Item Year 1 Year 2 Year 3
Structural $125,160 $129,165 $137,690
Roofing $14,280 $14,637 $15,076
Heat etc. $35,560 $36,306 $37,614
Insulating $9,522 $10,093 $10,850
Labor $89,250 $93,266 $97,463
Total $273,772 $283,467 $298,693

(a) $89,250; $93,266; $97,463

(b) PW = $9,522 (P/F, 25%, 1) + $10,093 (P/F, 25%, 2)


+ $10,850 (P/F, 25%, 3)
= $19,632

(c) FW = ($9,522 + $89,250) (F/P, 25%, 2) + ($10,093


+ $93,266) (F/P, 25%, 1) + ($10,850 + $97,463)
= $391,843

(d) PW = $273,772 (P/F, 25%, 1) + $283,467 (P/F, 25%, 2)


+ $298,693 (P/F, 25%, 3)
= $553,367

14-43
The total cost of the bike 10 years from today would be $2,770

Current Future
Item Cost Inflation Cost
Frame 800 2.0% 975.2
Wheels 350 10.0% 907.8
Gearing 200 5.0% 325.8
Braking 150 3.0% 201.6
Saddle 70 2.5% 89.6
Finishes 125 8.0% 269.9

Sum= 1695 Sum= 2769.8


14-44
To minimize purchase price Mary Clare should select the vehicle from company X.

Current Future
Car Price Inflation Price
X 27500 4.0% 30933.8
Y 30000 1.5% 31370.4
Z 25000 8.0% 31492.8

Min= 30933.8

14-45
FYEAR 5 = $100 (F/A, 12/4=3%, 5 x 4=20) = $2,687

FYEAR 10 = $2,687 (F/P, 4%, 20) + $100 (F/A, 4%, 20) = $8,865

FYEAR 15 (TODAY) = $8,865 (F/P, 2%, 20) + $100 (F/A, 2%, 20) = $15,603

14-46
To pay off the loan Andrew will need to write a check for $ 18,116

Amt due Amt due


Year Begin yr Inflation End yr
1 15000 5.0% 15750.0
2 15750.0 6.5% 16773.8
3 16773.8 8.0% 18115.7
Due= 18115.7
14-47
See the table below for (a) through (e)

Ave Inflation
Year Price for year
5 years ago 165000.0 (a) = 1.2%
4 years ago 167000.0 (b) = 3.0%
3 years ago 172000.0 (c) = 4.7%
2 years ago 180000.0 (d) = 1.7%
last year 183000.0 (e) = 3.8%
This year 190000.0 (f) see below
One could predict the inflation (appreciation) in the home prices this year using a number of
approaches. One simple rule might involve using the average of the last 5 years inflation
rates. This rate would be (1.2+3+4.7+1.7+3.8)/5 = 2.9%.
14-48
Depreciation charges that a firm makes in its accounting records allow a profitable firm to
have that amount of money available for replacement equipment without any deduction for
income taxes.

If the money available from depreciation charges is inadequate to purchase needed


replacement equipment, then the firm may need also to use after-tax profit for this purpose.

Depreciation charges produce a tax-free source of money; profit has been subjected to
income taxes. Thus substantial inflation forces a firm to increasingly finance replacement
equipment out of (costly) after-tax profit.

14-49
(a)
Year BTCF SL TI 34% ATCF
Deprec Income
. Taxes
0 -$85,000 -$85,000
1 $8,000 $1,500 $6,500 -$2,210 $5,790
2 $8,000 $1,500 $6,500 -$2,210 $5,790
3 $8,000 $1,500 $6,500 -$2,210 $5,790
4 $8,000 $1,500 $6,500 -$2,210 $5,790
5 $8,000 $1,500 $6,500 -$2,210 $83,290
$77,500 $0
Sum $7,500

SL Depreciation = ($67,500 - $0)/45 = $1,500


Book Value at end of 5 years = $85,000 – 5 ($1,500) = $77,500

After-Tax Rate of Return = 5.2%

(b)
Year BTCF SL TI 34% Actual
Deprec Income Dollars ATCF
. Taxes
0 -$85,000 -$85,000
1 $8,560 $1,500 $7,060 -$2,400 $6,160
2 $9,159 $1,500 $7,659 -$2,604 $6,555
3 $9,800 $1,500 $8,300 -$2,822 $6,978
4 $10,486 $1,500 $8,986 -$3,055 $7,431
5 $11,220 $1,500 $9,720 -$3,305 $131,913
$136,935* -$16,242**
Sum $7,500

*Selling Price = $85,000 (F/P, 10%, 5) = $85,000 (1.611) = $136,935


** On disposal, there are capital gains and depreciation recapture
Capital Gain = $136,935 - $85,00 = $51,935
Tax on Cap. Gain = (20%) ($51,935) = $10,387
Recaptured Depr. = $85,000 - $77,500 = $7,500
Tax on Recap. Depr. = (34%)($7,500) = $2,550
Total Tax on Disposal = $10,387 + $2,550 = $12,937

After Tax IRR = 14.9%

After-Tax Rate of Return in Year 0 Dollars

Year Actual Dollars Multiply by Year 0


ATCF $ ATCF
0 -$85,000 1 -$85,000
1 $6,160 1.07-1 $5,757
2 $6,555 1.07-2 $5,725
3 $6,978 1.07-3 $5,696
4 $7,431 1.07-4 $5,669
5 $131,913 1.07-5 $94,052
Sum

In year 0 dollars, After-Tax Rate of Return = 7.4%

14-50
Year BTCF TI 42% ATCF Multiply by Year 0 $ ATCF
Income
Taxes
0 -$10,000 -$10,000 1 -$10,000
1 $1,200 $1,200 -$504 $696 1.07-1 $650
2 $1,200 $1,200 -$504 $696 1.07-2 $608
3 $1,200 $1,200 -$504 $696 1.07-3 $568
4 $1,200 $1,200 -$504 $696 1.07-4 $531
5 $1,200 $1,200 -$504 $10,696 1.07-5 $7,626
$10,000
Sum -$17

(a) Before-Tax Rate of Return ignoring inflation


Since the $10,000 principal is returned unchanged,
i = A/P = $1,200/$10,000 = 12%

If this is not observed, then the rate of return may be computed by conventional means.

$10,000 = $1,200 (P/A, i%, 5) + $10,000 (P/F, i%, 5)


Rate of Return = 12%

(b) After-Tax Rate of Return ignoring inflation


Solved in the same manner as Part (a):
i = A/P = $696/$10,000 = 6.96%

(c) After-Tax Rate of Return after accounting for inflation


An examination of the Year 0 dollars after-tax cash flow shows the algebraic sum of the
cash flow is -$17. Stated in Year 0 dollars, the total receipts are less than the cost,
hence there is no positive rate of return.

14-51
Now:
Taxable Income = $60,000
Income Taxes = $35,000x0.16+25,000x0.22 = $11,100
After-Tax Income = $60,000 - $11,100 = $48,900

Twenty Years Hence: To have some buying power, need:


After-Tax Income = $48,900(1.07)20 = $189,227.60
= Taxable Income – Income Taxes

Income Taxes = $24,689.04+0.29(Taxable Income - $113,804)

Taxable Income = After-Tax Income + Income Taxes


= $189,227.60+$24,689.04+0.22(TI - $113,804)
= $242,153.50

14-52
P= $10,000
CCA= 30%
t= 50%
S= 0
f= 7%
Actual $s Actual Actual $s Net Actual $s Real $s
Year Received CCA Tax Salvage ATCF ATCF
0 -$10,000 -$10,000 -$10,000
1 $2,000 -$1,500 $250 $1,750 $1,636
2 $3,000 -$2,550 $225 $2,775 $2,424
3 $4,000 -$1,785 $1,108 $2,893 $2,361
4 $5,000 -$1,250 $1,875 $3,125 $2,384
5 $6,000 -$875 $2,563 $3,437 $2,451
6 $7,000 -$612 $3,194 $3,806 $2,536
7 $8,000 -$429 $3,786 $500 $4,714 $2,936
IRR= 13.71%

Net Salvage Calculation from Equation 12-7, 12-8, & 11-8


UCC7 = $1,000 =$B$1*(1-$B$2/2)*(1-$B$2)^(7-1)
Net Salvage end of yr 7 = $500

=$B$4+$B$3*IF($B$4>$B$1,$C$18-$B$1,$C$18-$B$4)-1/2*$B$3*MAX(($B$4-$B$1),0)
14-53
P= $103,500
CCA= 10%
t= 35%
S= $ 103,500
f= 0%
Actual $s Actual Actual $s Net Actual $s Real $s
Year Received CCA Tax Salvage ATCF ATCF
0 -$103,500 -$46,500 -$150,000 -$150,000
1 $15,750 -$5,175 $3,701 $12,049 $12,049
2 $15,750 -$9,833 $2,071 $13,679 $13,679
3 $15,750 -$8,849 $2,415 $13,335 $13,335
4 $15,750 -$7,964 $2,725 $13,025 $13,025
5 $15,750 -$7,168 $3,004 $136,354 $149,100 $149,100
7.06% =IRR

Net Salvage Calculation from Equation 12-7, 12-8, &


11-8
UCC5 =$64,511 =$B$1*(1-$B$2/2)*(1-$B$2)^(5-1)
Net Salvage end of yr 5 = $89,854

=$B$4+$B$3*IF($B$4>$B$1,$C$18-$B$1,$C$18-$B$4)-1/2*$B$3*MAX(($B$4-$B$1),0)

14-54
P= $103,500
CCA= 10%
t= 35%
S= $ 103,500
f= 10%

Actual $s Actual Actual $s Real $s


Actual $s Tax Net Salvage
Received CCA ATCF ATCF
Year
0 -$103,500 -$46,500 -$150,000 -$150,000
1 $12,000 -$5,175 $2,389 $9,611 $8,738
2 $13,440 -$9,833 $1,263 $12,177 $10,064
3 $15,053 -$8,849 $2,171 $12,882 $9,678
4 $16,859 -$7,964 $3,113 $13,746 $9,389
5 $18,882 -$7,168 $4,100 $230,694 $245,476 $152,421

16.01% 5.46% =IRR

Net Salvage Calculation from Equation 12-7, 12-8, & 11-8


UCC5 = $64,511 =$B$1*(1-$B$2/2)*(1-$B$2)^(5-1)

Net Salvage end of yr 5 = $89,854

=$B$4+$B$3*IF($B$4>$B$1,$C$18-$B$1,$C$18-$B$4)-1/2*$B$3*MAX(($B$4-$B$1),0)

Market Value in 5 years = 150000 x (1+12%)^5 $264,351.25


house value $103,500.00
land sale $160,851.25
capital gain's
tax $ 20,011.47
net land
salvage $140,839.78

14-55
Alternative A
Year Cash Cash SL TI 25% ATCF in ATCF in
Flow in Flow in Deprec. Income Actual $ Year 0 $
Year 0 $ Actual $ Tax
0 -$420 -$420 -$420 -$420
1 $200 $210 $140 $70 -$17.5 $192.5 $183.3
2 $200 $220.5 $140 $80.5 -$20.1 $200.4 $181.8
3 $200 $231.5 $140 $91.5 -$22.9 $208.6 $180.2

Alternative B
Year Cash Cash SL TI 25% ATCF in ATCF in
Flow in Flow in Deprec. Income Actual $ Year 0 $
Year 0 $ Actual $ Tax
0 -$300 -$300 -$300 -$300
1 $150 $157.5 $100 $57.5 -$14.4 $143.1 $136.3
2 $150 $165.4 $100 $65.4 -$16.4 $149.0 $135.1
3 $150 $173.6 $100 $73.6 -$18.4 $155.2 $134.1

Quick Approximation of Rates of Return:

Alternative A:
$420 = $182 (P/A, i%, 3)
(P/A, i%, 3) = $420/$182 = 2.31
12% < ROR < 15%
(Actual ROR = 14.3%)

Alternative B:
$300 = $135 (P/A, i%, 3)
(P/A, i%, 3) = $300/$135 = 2.22
15% < ROR < 18%
(Actual ROR = 16.8%)

Incremental ROR Analysis for A- B


Year A B A- B
0 -$420 -$300 -$120
1 $183.3 $136.3 $47
2 $181.8 $135.1 $46.7
3 $180.2 $134.1 $46.1

Try i = 7%
NPW = -$120 + $47 (P/F, 7%, 1) + $46.7 (P/F, 7%, 2)
+ $46.1 (P/F, 7%, 3)
= +$2.3

So the rate of return for the increment A- B is greater than 7% (actually 8.1%). Choose the
higher cost alternative: choose Alternative A.

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