Engineering Economic Analysis Canadian Edition Chapter 14: Inflation and Price Change

Chapter 14 … Describes inflation, explains how it occurs, and lists its effects on purchasing power. Defines $ values and interest rates as either real or nominal. Demonstrates how to analyze real and nominal cash flows, based on constant or varying inflation rates, using before-tax or after-tax amounts. Introduces price indexes.

Meaning and Effect of Inflation Inflation erodes the value of $1 of currency; i.e. it makes future dollars less valuable than present dollars. A sandwich that cost $3.00 last year and $3.06 this year is an example of individual item inflation of 2% per year. If the average price of a loaf of bread moves from $3.15 last year to $3.38 this year, the commodity ‘bread’ has inflated 7.3% per year. If a market basket of goods used by the average individual costs $141.96 this year versus $140.00 last year, general consumer prices have risen by 1.4% per year.

Effect of Inflation Inflation causes the value of money to be reduced in the future. Inflation tends to cause goods and services to cost more as time increases. Inflation is pervasive. Many industrialized countries endeavour to maintain inflation at a level between about 1% and 3% per year. Deflation is negative inflation, when goods cost less in the future. Deflation is rare.

Why Does Inflation Occur? Money supply increases: money available to consumers in the economy increases faster than the value of goods available. Exchange rates: prices change to reflect the comparative value of currencies in different countries. Cost-push inflation: producers raise prices to cover costs. Demand-pull inflation: consumers bid up prices when goods are in short supply.

Interest Rate Definitions Inflation rate (f): rate of change of the cost of an item, commodity, or market basket of goods. Real interest rate (i’): ‘real’ interest earned on an investment — the inflation-free interest rate. Nominal interest rate (i): the interest paid for borrowing money in the open market, the combined interest rate. The nominal interest rate also includes a margin for the lender’s risk.

Calculation of Inflation (1+i) = (1+i’)(1+f) i = i’ + f + (i’)(f)

Nominal & Real Dollars Definitions Nominal dollars: cash money — the kind you carry in your pocket; includes the effects of inflation. Real dollars: dollars with constant purchasing power, expressed using a base year; e.g. 2002-based dollars. These are inflation-free (fictitious) dollars.

Inflation Examples Your father says his monthly salary was $1075 in 1974. You expect your monthly salary will be $4950 when you graduate in 2010. If inflation has averaged 4.35% per year between 1974 and 2010, whose salary is higher (in real value)? Your father invested $10,000 in 1974 in deposit bonds that give an annual rate of return of 5.65%. Calculate the maturity value in 2010 and find the real rate of return, using the same rate of inflation as above.

Nominal and Real Dollars Analysis Analysis must be consistent: either real $ with real interest rates, or nominal $ with nominal interest rates, but never mixed. Results are usually the same with no taxes. After tax results are different because some cash flows (e.g. depreciation and interest) do not inflate.

Example without and with taxes

Price Changes with Indexes Indexes track and describe relative price changes over time. Indexes can be for a specific commodity or composite for a bundle of commodities. Statistics Canada tracks price levels and publishes the Consumer Price Index (CPI) for Canada and for each province. See http://www.statcan.gc.ca/subjects-sujets/cpi-ipc/cpi-ipc-eng.htm and the chart on the next page.

Price Changes with Indexes … Rate of inflation as reported on July 17, 2009. Source: Statistics Canada.

Price Changes with Indexes … The base value for the CPI is 100 and the base year is 2002. The CPI in June, 2009, was 115.1. A market basket of goods and services that cost $100 in 2002 had a cost of $115.10 in June, 2009. The CPI in June, 2008, was 115.4; hence the annual rate of inflation in June, 2009, was (115.1/115.4 –1=) –0.2600%. The market price level of goods and services decreased by 0.2600% from June/08 to June/09. A negative inflation rate was last observed in November 1994.

Inflation Issues Different cash flows can inflate at different rates; it is usually better to use nominal cash flows with nominal interest rates. Example: A firm is considering an investment that requires an initial outlay of $350K. The expected annual revenue is $250K and the annual cost is $165K (amounts are in today’s dollars). During the ten-year life of the investment, it is expected that the revenue will grow at 2% per year and the cost at 3% per year. Determine if your firm should accept this investment if it uses a nominal MARR of 13%. The marginal tax rate is 30% and the firm uses straight-line depreciation.

Inflation Issues … The inflation rate can change during the analysis period of a project. Apply the inflation rate on a year-by-year basis and then find the measure of merit. An investment requires an initial outlay of $1m. Annual net earnings will be $210K before tax. After a six-year life, the salvage value will be $140K. All $ amounts are in today’s dollars. For the first three years, the annual inflation rate will be 2%; for the second three years, it will be 4%. The nominal MARR is 14%. The CCA rate is 30% and the tax rate is 32%. Should the investment be accepted?

Suggested Problems 14-12, 20, 26, 28, 35, 42, 49, 55.