IE 302: Engineering Economic Analysis

Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

Chapter 11 – Inflation and Its Impact on Project Cash Flows

• _________________
inflation – ___________
Loss of ________________________
Purchasing power of money over time
o Cost of an item or service ______________
increasing over time

• Deflation
_________________ Increase
– ___________ of ________________________
purchasing power of money over time
o Cost of an item or service ______________
Decreasing over time
• compound
Like TVOM, inflation/deflation _____________________ over time

Source: Flex Coaching, http://www.flexcoaching.com/inflation/

Example 8 - 1 What has been the rate of inflation for bread in the last 30 years?

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 IE 302: Engineering Economic Analysis
Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

• price indices
Inflation is measured using ___________________ – statistics used to determine how the
price of _________________
commodities (or groups of commodities) change over time
o __________________________________
consumer price index (Cpi) – measures price of goods and services
required by the average consumer
_________________ Price Index
o producer PPI – measures price of industrial goods
250.0 16.0%
225.0 Consumer Price 14.0%
Index
200.0
12.0%

CPI-Based Inflation Rate

175.0
10.0%
Consumer Price Index

150.0
8.0%
125.0
6.0%
100.0
75.0
4.0%
50.0 2.0%
25.0 0.0%
0.0 -2.0%
1961

1966

1971

1976

1981

1986

1991

1996

2001

2006
**Price increases in one segment of the economy are generally felt in all segments of the economy, e.g., oil prices

• multinational
Especially important to consider inflation in ______________________________ situations.
o _______________________
currency exchange and ________________
inflation can impact the viability of a project

Inflation in 2017 (map from http://www.imf.org/)

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 IE 302: Engineering Economic Analysis
Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

Two equivalent approaches can be used to consider inflation in an economic justification:

1.Actual dollars (current, nominal) An– out of pocket dollars pay
________________________________ at the time
_____________________
of the cash flow
• When estimating future cash flows, need to take into account the
_______________________
effect of inflation
2. _____________________________–
Constant dollars (real) An’ dollars in some _________________
base year (e.g., 2018
year dollars) used to adjust for the effects of inflation
• Assume base year is n = 0 and then use accepted _____________________________
general inflation rate
to adjust future cash flows
** It is essential that the cash flows be consistent – either they both include inflation, or they
both ignore inflation.

1900: 2018:

Constant
Dollar, 1900:
$0.05 $0.05
Constant
Dollar, 2018:
$1.50 $1.50
Actual Dollar $0.05 $1.50

Notation

An = Actual dollar expression for the cash flow at the end of year n
An’ = Constant-dollar expression for the cash flow at the end of year n
eg. 2018 dollars
f = General inflation rate
avg

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 IE 302: Engineering Economic Analysis
Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

Conversion between Constant- and Actual- Dollars

Example 8 - 2 You purchase a house and secure a 30-year mortgage (i.e., a loan for houses).
The monthly payment is $1500 in 2018. Assuming an average inflation rate of 4% per year,
what will be the equivalent constant-dollar cost during the last year of your mortgage
payments?

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 IE 302: Engineering Economic Analysis
Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

Example 8 - 3 The cost of a base model Ford Mustang in 1965, the first year it was produced,
was $2,321. Assuming an average inflation rate of 5%, how much would you expect a Ford
Mustang to cost in 2015?

Equivalence Calculations under Inflation

Depending upon which type of analysis we want to do, we will need to use either
• ___________________
market rate interest rate – includes both _____________
earning and
____________
purchasing power; typically the interest rate quoted by financial institutions
o Examples – loan rate, savings account
o Used in _______________________
Actual dollar (An) analysis
o Most companies use this to determine their MARR (i.e., inflation-adjusted MARR)
• __________________________interest
inflation free rate i’ – estimate of the true ____________
earning power
_____________________ of money when the inflation affects have been removed
o Used in _________________________
Constant dollars (An’) analysis
o Commonly known as the real
________________ interest rate
• In the absence of inflation, inflation-free interest rate =market
______________ interest rate
• We can convert between the market and inflation free interest rates

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 IE 302: Engineering Economic Analysis
Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

Two types of analysis:

1. ________________________
constant dollar analysis – all cash flows are given in constant dollars
o Use the constant dollar cash flows and use the __________________
inflation free interest rate
to calculate the present worth
2. ________________________
actual dollar analysis – all cash flows are given in actual dollars
o Two ways to complete the method:
1. _____________________
Deflation method – two step method which ______________
convert
the problem into a _______________________
constant dollar analysis
1. convert _______________
actual dollars into ________________
constant dollars to
remove inflationary effects

2. compute the present worth using constant dollar cash flow and the
_____________________
inflation free interest rate
o ________________________
adjusted discount method – ____________
combine discounting and deflation
• Use the actual cash flowsAn and ______________
market interest rate to
compute present worth equivalent
• Use _______________ interest rate and _______________ cash flows

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 IE 302: Engineering Economic Analysis
Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

Examples

Example 8 - 4 An entrepreneur is trying to decide whether or not to pursue an opportunity to

invest in a business with the following projected cash flows given in 2018 dollars. The
entrepreneur is willing to invest in this opportunity if he earns an inflation free return of at least
15%. Complete a constant-dollar analysis. Would you recommend that the entrepreneur
invest in this opportunity?

n An'
0 $(25,000)
1 $7,500
2 $8,000
3 $6,000
4 $8,000

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 IE 302: Engineering Economic Analysis
Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

Example 8 - 5 A company is trying to determine whether or not it should invest in a new tractor
trailer so that it can do its own logistics instead of hiring a carrier to do them. The estimated
cash flows are given below in actual dollars. The company assumes an inflation rate of 6%, and
uses an inflation free interest rate of 12%. Complete an actual dollar analysis using both the
deflation and adjusted discount method.

n An An’ Equivalent PW

0 $(150,000)

1 $60,000

2 $68,000

3 $72,000

4 $80,000

5 $85,000

PW

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 IE 302: Engineering Economic Analysis
Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

Example 8 - 6 For the next 4 years, I anticipate buying $3600 worth of groceries each year (in
today’s dollars). If inflation is expected to be 3% per year, what are the constant dollar and
actual dollar cash flows?

If I wanted to invest money today to cover the cost of groceries over the next 4 years, how
much would they need to invest if they earn a market interest rate of 6% per year on their
investments? Perform a constant and actual dollar analysis.

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 IE 302: Engineering Economic Analysis
Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

Example 8 - 7 We previously considered a number of loan problems. Assume that we borrow

$5,000 to be paid back over a 5-year period, with a loan rate of 8%. Is the 8% loan rate the
market interest rate or the inflation free interest rate? Explain your answer.

Using a uniform payment plan, determine the actual (then-current) cash flows and the constant
dollar cash flows if inflation is 2.5%. Ensure that the present worth of these cash flows equals
$5000.

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 IE 302: Engineering Economic Analysis
Notes prepared by Dr. Sarah Root with input from Dr. Tish Pohl
Note Set 8 – Inflation

Example 8 - 8 A software company’s labor requirements cost $350,000 during year one. The
labor-hour requirements are expected to increase by 10% per year over the next 5 years. If
inflation is 4% and the inflation-free interest rate is 8%, determine the PW of the labor costs
using both constant dollar analysis and actual dollar analysis.

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