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Measure of Inflation Actual versus Constant Dollars Equivalence Calculations under Inflation
Measure of Inflation
This chapter:
Define and quantify inflation Apply it in several equivalence analyses
Measuring inflation effect Eight major groups based on a typical market basket of goods and services required by the average consumer: (1) food and alcoholic beverages, (2) housing, (3) apparel, (4) transportation, (5) medical care, (6) entertainment, (7) personal care, and (8) other goods and services CPI compares the cost of the typical market basket of goods and services in a current month with its cost at a previous time, such as 1 month, 1 year, or 10 years ago
Consumer Price Index: good measure of the general price increase of consumer products, not a good measure of industrial price increases Performing engineering economic analysis, the appropriate price indices must be selected to accurately estimate the price increases of raw materials, finished products, and operating costs
To account for the effect of varying yearly inflation rates over a period of several years. A single rate that represents an average inflation rate Each year's inflation rate based on the previous year's rate, these rates have a compounding effect
Example: to calculate the average inflation rate for a twoyear period. The first year's inflation rate is 4%, and the second year's rate is 8%, with a base price of $100 First Year 100(1 + 0.04)(1 + 0.08) = 112.32 Second Year 100(1+f)2 = 112.32 or 100(F/P,f,2) = 112.32 f = 5.98%
General inflation rate (f ): this average inflation rate is calculated based on the CPI for all items in the market basket. The market interest rate is expected to respond to this general inflation rate Specific inflation rate(fi): This rate is based on an index (or the CPI) specific to segment j of the economy In terms of CPI, the general inflation rate defined as CPIn = CPI0(I + f)n or f [CPIn ]1/n 1 CPI0 Where:
CPIn : the consumer price index at the end period n CPI0 : the consumer price index at the end period 0 f: the general inflation rate
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Road Map
Measure of Inflation Actual versus Constant Dollars Equivalence Calculations under Inflation
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Actual (current) dollars (An): Actual dollars are estimates of future cash flows for year n that take into account any anticipated changes in amount caused by inflationary or deflationary effects. Actual dollars are the amount of dollars that will be paid or received irrespective of how much these dollars are worth. Usually, these amounts are determined by applying an inflation rate to base-year dollar estimates
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Constant (real) dollars (An): Constant dollars reflect constant purchasing power independent of the passage of time. Constant dollars are a measure of worth not an indicator of the number of dollars paid or received. In situations where inflationary effects were assumed when cash flows were estimated, these estimates can be converted to constant dollars (base-year dollars) by adjustment using some readily accepted general inflation rate
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Constant dollars represent dollar amounts expressed in terms of the purchasing power of the base year An = An(1 + f)n = An(F/P,f,n) where An = the constant-dollar expression for the cash flow occurring at the end of year n and An = the actual-dollar expression for the cash flow occurring at the end of year n.
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Transco Company is considering making and supplying computer-controlled traffic-signal switching boxes to be used throughout Arizona. Transco has estimated the market for its boxes by examining data on new road construction and on deterioration and replacement of existing units. The current price per unit is $550; the before-tax manufacturing cost is $450.The start-up investment cost is $250,000.The projected sales and net before-tax cash flows in constant dollars are as below: Assume that the price per unit and the manufacturing cost keep up with the general inflation rate, which is projected to be 5% annually. Convert the project's before-tax cash flows into the equivalent actual dollars.
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Table:
Period 0 1 2 3 1,000 1,100 1,200 Units Sale Net Cash Flow in Constant $ -250,000 100,000 110,000 120,000
4
5
1,300
1,400
130,000
120,000
Given: Net cash flows in Constant $, f = 5%. Find: Net cash flows in actual $.
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Period
Conversion Factor
0 1
2 3 4 5
-250,000 100,000
110,000 120,000 130,000 120,000
1 (1+0.05)1
(1+0.05)2 (1+0.05)3 (1+0.05)4 (1+0.05)5
105,000
121,275
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The reverse of converting from constant to actual dollars An = An/(1 + f)n = An(1 + f)-n = An(P/F,f,n) Where: An = the constant-dollar expression for the cash flow occurring at the end of year n and An = the actual-dollar expression for the cash flow occurring at the end of year n.
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Road Map
Measure of Inflation Actual versus Constant Dollars Equivalence Calculations under Inflation
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For Case 3, simply convert all cash flow elements into one type-either constant or actual dollars, then proceed with either constant-dollar analysis as for Case 1or actual-dollar analysis as for Case 2.
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Constant-Dollar Analysis
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Actual-Dollar Analysis
To find the equivalent present worth of this actual dollar amount (An) in year n, to use either: Deflation method:
Step 1: Bring all cash flows to a common purchasing power. Step 2: Consider the earning power
Adjusted-discount method:
Combine Steps 1 and 2 into one step
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Equivalence Calculation When Cash Flows Are in Actual Dollars: Deflation Method
Applied Instrumentation, a small manufacturer of custom electronics, is contemplating an investment to produce sensors and control systems that have been requested by a fruit-drying company. The work would be done under a proprietary contract that would terminate in five years. The project is expected to generate the following cash flows in actual dollars:
n 0 1 2 3 Net Cash Flow in Actual Dollars -75,000 32,000 35,700 32,800
4
5
29,000
58,000
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Equivalence Calculation When Cash Flows Are in Actual Dollars: Deflation Method
a) What are the equivalent year-zero dollars (constant dollars) if the general inflation rate (f) is 5% per year? b) Compute the present worth of these cash flows in constant dollars at i = 10%. Given: Cash flows stated in actual $, f = 5%, and i' = 10%. Find: Equivalent present worth using the deflation method.
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Equivalence Calculation When Cash Flows Are in Actual Dollars: Deflation Method
3 4
5
32,800 29,000
58,000
(1+0.05)-3 (1+0.05)-4
(1+0.05)-5
28,334 23,858
45,445
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Equivalence Calculation When Cash Flows Are in Actual Dollars: Deflation Method
b) We use i' = 10% to compute the equivalent present worth of constant dollars
N 0 1 2 Net Cash Flow in Constant Dollars -75,000 30,476 32,381 Deflation Factor 1 (1+0.1)-1 (1+0.1)-2 Net Cash Flow in Constant Dollars -75,000 27,606 26,761
3 4
5
28,334 23,858
45,445
(1+0.1)-3 (1+0.1)-4
(1+0.1)-5
21,288 16,295
28,218
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Equivalence Calculation When Cash Flows Are in Actual Dollars: Deflation Method
The adjusted-discount method performs deflation and discounting in one step An An (1 f)n Pn (1 i')n (1 f)n (1 i')n Since the market interest rate i reflects both the earning power and the purchasing power
(1+i)n = (1+f)n(1+i) or i = i + f + if This equation implies that the market interest rate is a function of two terms i and f
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An pn n (1 i) n
Equivalence Calculation When Cash Flows Are in Actual Dollars: Adiusted-Discounted Method
Consider the cash flows in actual dollars in above Example. Compute the equivalent present worth of these cash flows, using the adjusteddiscount method. Given: Cash flows stated in actual $, f = 5%, and i' = 10%. Find: Equivalent present worth using the adjusted-discounted method.
n 0 1 2 3
4
5
29,000
58,000
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Equivalence Calculation When Cash Flows Are in Actual Dollars: Adiusted-Discounted Method
First, to determine the market interest rate i: i = i + f + if = 0.1 + 0.05 + 0.1*0.05 = 15.5%
n 0 1 2 3 4 5
Net Cash Flow in Constant Dollars -75,000 32,000 35,700 32,800 29,000 58,000
Net Cash Flow in Constant Dollars -75,000 27,606 26,761 21,288 16,295 28,218
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Mixed-Dollar Analysis
A couple wishes to establish a college fund at a bank for their five-yearold child. The college fund will earn 8% interest compounded quarterly. Assuming that the child enters college at age 18, the couple estimates that an amount of $30,000 per year. in terms of today's dollars, will be required to support the child's college expenses for four years. College expenses are estimated to increase at an annual rate of 6%. Determine the equal quarterly deposits the couple must make until they send their child to college. Assume that the first deposit will be made at the end of the first quarter and that deposits will continue until the child reaches age 17. The child will enter college at age 18. and the annual college expense will be paid at the beginning of each college year. In other words. the first withdrawal will be made when the child is 18. In this problem, future college expenses are expressed in terms of today's dollars, whereas the quarterly deposits are in actual dollars. Since the interest rate quoted for the college fund is a market interest rate: we may convert the future college expenses into actual dollars:
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Mixed-Dollar Analysis
Given: A college savings plan, i = 2% per quarter, N = 12 years. Find: Amount of quarterly deposit in actual $. First to covert future College expense into actual dollars:
Age 18
19 20 21
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Mixed-Dollar Analysis
Approach: Convert any cash flow elements in constant dollars into actual dollars, then use the market interest rate to find the equivalent present value. Assume the couple deposit an amount of C dollars quarterly. The college expenses as well as the quarterly deposit series now in actual dollars shown in Figure below:
76211 71897 67827
63988 Age 5
C
7 ...16
17
18 19 20 21
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Mixed-Dollar Analysis
We first select n = 12, or age 17, as the base period for our equivalence calculation, i.e. to calculate total equivalent money V1 deposit at age 17 and the equivalent worth V2 of total money expense also at age 17, then set V1 = V2 to find C Interest Rate: APR = 8% or 2% quarterly
Tutorial
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