IEN255 Chapter 11 - Inflation Inflation vs Deflation Inflation - a loss in purchasing power of money over time Deflation - prices decrease of time Measuring inflation - Consumer Price Index (CPI) Survey of Current Business - for industrial products

Average inflation rate (f) Step 1 - simple compounding $100(1 + 0.04)(1 + 0.08) = $112.32 Step 2 - equiv eqn $100(1 + f)2 = $112.32 solve for f

General inflation rate vs Specific General Inflation Rate ( ) - average inflation rate calculated based on the CPI Specific Inflation Rate (fj) - inflation rate calculated based on a specific segment j of the economy. (if just one item, drop the subscript j) equations 11.1 and 11.2 with defs

Example 11.2

Actual vs Constant Dollars Actual (current) dollars - estimates of future cash flows for year n that take into account any anticipated changed in amount due to inflation Constant (real) dollars - constant purchasing power independent of time (adjusted using an accepted general inflation rate) To convert use 11.4 where A’n = constant dollar expression for the cash flow where An = actual dollar expression for the cash flow

Example 11.3

Figure 11.1

Conversion from Actual to Constant Dollars (11.5) example 11.4

Equivalence calculations under inflation Two Types Market Interest Rate (i) (typically inflation-adjusted MARR) Inflation-free Interest Rate (i’)- real interest rate (prev chaps) Case 1: All in constant dollars Case 2: All in actual dollars Case 3: Mix (convert all to either case 1 or 2)

Constant Dollar Analysis Example 11.5

Actual Dollar Analysis Deflation method copy page 573

Actual Dollar Analysis cont Adjusted discount method example 11.7 figure 11.3

Mixed Dollar Analysis Page 577 and 578

Effects of Inflation on Project Cash Flows Depreciation Expenses under Inflation page 581

Multiple Inflation Rates Table 11.3

Multiple Inflation Rates Solution on page 583

Effects of Borrowed Funds under Inflation Solution on page 584

Effects of Borrowed Funds under Inflation Page 585

Rate of Return Analysis Under Inflation Table 11.5

Rate of Return Analysis Under Inflation RoR without inflation PW(i’) = -30,000+12,700(P/F,i’,1) + 14,033 (P/F,i’,2) + 10,478 (P/F,i’,3) + 9,589 (P/F,i’,4) Solve for IRR’ = i’* = 21.88% RoR under inflation PW(i’) = -30,000+12,336(P/F,i’,1) + 13,108 (P/F,i’,2) + 10,036 (P/F,i’,3) + 9,307 (P/F,i’,4) Solve for IRR’ = i’* = 19.40%

Rate of Return Analysis Under Inflation put table 11.5 and 11.6 on the same page next to each other (shrink if necessary)

Effect of Inflation on Working Capital Figure 11.6

Table 11.7

IEN255 Summer’99 Chapter 10,11,13 HW#4 Homework Assignment: Chapter 10 #’s 10.4; 10.6; 10.24 Chapter 11 #’s 11.1; 11.6; 11.13 Chapter 13 #’s 13.9 Due together (Tues July 27)