engineering economics in canada chapter 9 inflation

Engineering Economics in Canada

Chapter 9 Inflation

Copyright © 2006 Pearson Education Canada Inc. 9-2

• Inflation: An increase in the average price paid for goods and services over time. – Results in a reduction in purchasing power.

• Deflation: A decrease in the average price paid for goods in services over time.– Results in an increase in purchasing power.

• Different ideas: time value of money, interests, tax.

Review


• If we expect inflation, the actual dollars returned by a project does not reflect the actual purchasing power of the future cash flow.

• The purchasing power depends on the real dollar value of the earnings

ReviewEffect of Inflation on the MARR


• The actual value of $M invested for one year at an actual interest rate i:

M (1 + i)• If the inflation rate over the next year is f,

the real value of our cash flow is:

M(1+i)/(1+f)

Effect of Inflation on the MARR…


• The real interest rate, i’, is the interest rate that would yield the same number of real dollars in the absence of inflation as the actual interest rate yields in the presence of inflation:

Real Interest Rate

1)1/()1('

)1/()1()'1(

fii

fiMiM


The Effect of Inflation on the IRR(Not Required for Quiz)

• The effect of expected inflation on the actual IRR of a project is similar to the effect of inflation on the actual MARR.

• Say we have a project with a first cost A0 and actual cash flows A1, A2, …, AT

• The actual IRR can be found by solving for i in:

0)1(

)1()1(

-PW2

210

TT

i

A

i

Ai

AA


Actual IRR (Not Required for Quiz)

• An annual inflation rate f is expected over the T year life of the project.

• In terms of real dollars (base year = now), the stream of actual cash flows can be written as (note: R0 =A0)

• The expression which gives the actual IRR can be rewritten as:

TT, fR...,,fR,fRR 111 2210

0

)+1(

1 + +

)+1(

1 +

)1(1

2

221

0

T

TT

i

fR

i

fRifR

RPW


Real IRR (Not Required for Quiz)

• The real IRR is the rate of return obtained on the real dollar cash flows associated with the project. It is the solution for i’ in:

• What is the relationship between the real IRR and the actual IRR?

0

'1...

)'1()'1( 221

0

T

T

i

R

i

Ri

RR

fIRRfIRRIRR

or

fIRRIRR

realrealactual

actualreal

1)1/()1(


• The engineer typically has been given an observed, or actual, MARR

• As we have seen, the actual MARR consists of two parts: – the real MARR and– an adjustment for anticipated inflation

• The projected cash flows are often stated in real (current) dollars, i.e., they do not include adjustments for inflation

• The challenge is to recognize that we have an actual MARR, but real cash flows

9.5 Project Evaluation Methods With Inflation


• There are two correct ways to proceed:

• Method 1: Work with real cash flows and find the real MARR using an estimate of f

• Method 2: Adjust the real cash flows for inflation, i.e., get estimates of the actual cash flows using f , and apply the actual MARR

Project Evaluation Methods with Inflation…


• Sources of forecasts of f over the short term (<1 year) can be found in publications such as The Globe and Mail and Report on Business

• Longer term projects need longer term forecasts of inflation if some actual cash flows are fixed by contract

• Longer term forecasts will be estimates, with all the uncertainty of extrapolations, and hence it is wise to evaluate the project(s) over a range of possible inflation rates

Project Evaluation Methods with Inflation…


• A computer has a first cost of $3000 and is expected to bring about actual savings of $1700 in year 1 and $1800 in year 2.

• Expected actual salvage value at the end of 2 years is $500. Inflation is 5% per year and the real MARR is 12%.

• Based on an IRR analysis, should the project be undertaken?

Example 9-4


• Three approaches are possible:

1. Convert the actual cash flows into real cash flows and find the real IRR directly. Compare to the real MARR.

2. Use the actual cash flows to determine an actual IRR, convert to a real IRR and compare to the real MARR.

3. Use the actual cash flows to determine an actual IRR, convert the real MARR to an actual MARR.

Example 9-4: Answer


• Method 1: The actual cash flows are: –3000, 1700, 2300 (=1800 + 500 )

• The real cash flows are:

• Now, to get the real IRR, solve for i in:

• The real IRR is 14.65%.

Example 9-4: Answer

2086.17 and 1619.05 ,3000

)05.1(

2300 and

)05.01(1700

,30002

0)1(

17.2086)1(05.1619

30002

ii


• Method 2: Solve for the value of i such that:

• which gives an actual IRR of 20.36%.

• Converting to a real IRR we get

• which (with a small rounding error) is the same as we obtained working with real cash flows.

Example 9-4: Answer

0)1(

5001800)1(

17003000

2

ii

0.1463 11.05

1.2036

1)1(

IRR1IRR ACTUAL

REAL

f


• Method 3: use actual IRR and calculate actual MARR:

• All methods indicate that the IRR exceeds the MARR we should proceed with the project.

Example 9-4: Answer

ACTUALIRR

17.6%

(0.05) 0.12 0.05 0.12

f MARR f MARRMARR REALREALACTUAL


Summary

• Inflation and deflation defined• Measuring the inflation rate• Economic Evaluation with Inflation

– Converting between real and actual dollars• The Effect of Correctly Anticipated Inflation

– The effect of inflation on the MARR– The effect of inflation on the IRR

• Project evaluation Methods with Inflation

• Blue: calculation not required


Quiz 3---When and Where

• Quiz: Tuesday, Oct. 25, 2005 • 11:30 - 12:20 (Quiz: 30 minutes)• Tutorial: Wednesday, Oct. 26, 2005• ELL 168 Group 1 • (Students with Last Name A-M) • ELL 061 Group 2 • (Students with Last Name N-Z)


Quiz---Who will be there• CraigTipping [email protected]

• Group 1 (Last Name A-M) ELL 168

• LeYang [email protected]

• Group 2 (Last Name N-Z) ELL 061

• If you cannot make it, Email me before the quiz, not your TA!!!

• If you have emergency, Email or talk to your TA and me as early as possible.

• So far still there are students skipped Quiz 2 and did not contact me: “0” already.


Quiz----Recourse

• Visit my Homepage Please, you have my phone, Email, Address, all slides, quiz times.

• Make sure you are here is your job, NOT: Wei, BC ferry, Air Canada, Apollo 13, Sky Train, etc.

• Marks: Email and Talk to your TA if really needed, (find the correct one please) if no good, then you want to talk to me

• 1 mark is not that important


Quiz---Problems, Solutions

• All problems on sheet this time• Solutions will be given on Tutorial• Bring: Blank Letter Paper, Pen,

Formula Sheet, Calculator, Student Card

• Write: Name, Student No. and Email (Please……)


Quiz---Based on Chapter 7.8.9.

• Important: Wei’s Slides • Even More Important: Examples in

Slides (slides after 22 in class 17 not required for calculation)

• 1 Formula Sheet is a good idea• 3 Questions for 1800 seconds. • Wei used 907 seconds • Today’s content/slides not required


Project----Time Table

• Find your group: Mid-October• Select Topic: End of October• Survey finished: End of October• Project: November (3 Weeks)• Project Report Due: Final Quiz


Project----Requirements

• Group: 3-6 Students (sound be done now)• Topic: Practical, (means real data, reasonable

topic), could Email me for suggestion• Report Length: 15 pages-30 printed pages. • Report: On Time, Original• Marks: 1 mark to 1 report, one group• No spoon feed: Independent Team work• Report: 25 marks out of 100


Project Topic----What to do

• You Find the topic• Example: A Survey on effect of inflation

on high education in Canada (or third world country, USA, etc.)

• Example: Government approaches on economic adjustments and their effect.

• Example: Public Service and Inflation

• Hope: several papers will be published.


Project----Recourse

• Not your teaching group• Example: Government Web• Example: Library, Database, Google• Example: Economics Faculty• Example: Newspaper, TV• Example: Friends

engineering economics in canada chapter 9 inflation

Documents

actual irr

real marr

real irr

real cash flows

actual value

actual dollars

pearson education canada

real value