Dr. Md.
Atiqul Islam
PhD (UK), MSc (UK)
Professor
Department of Economics
University of Rajshahi
Course: ECON 1211 (Engineering Economics)
18 June 2025
Chapter 5
Effects of Inflation
Objectives of this Session
o To understand how inflation affects economic analysis.
o Distinguish between real and nominal interest rates.
o Perform Present Worth (PW), Future Worth (FW), and Capital
Recovery (CR) analyses adjusted for inflation.
❖ Inflation
▪ Inflation refers to the general rise in the prices of goods and services
over time, which leads to a decrease in the purchasing power of money.
▪ In project evaluations, we must account for inflation to avoid
underestimating future costs and overestimating revenues.
❖ Inflation
▪ Example:
If a piece of equipment costs $1,000 today and the inflation rate is 4%
annually, it will cost:
$1,000 × (1 + 0.04) = $1,040 in one year.
❖ Effect of Inflation on Engineering Economic Decisions
▪ In long-term engineering projects, ignoring inflation can lead to
underestimating costs or overestimating benefits.
▪ For accurate project evaluation, inflation must be reflected in all financial
estimations—especially when dealing with costs or revenues in future years.
❖ Effect of Inflation on Engineering Economic Decisions
▪ Real vs. Nominal Interest Rate:
(1 + 𝑖) = (1 + 𝑓)(1 + 𝑟)
Where:
𝑖 ∶ Nominal interest rate includes inflation
𝑓 ∶ Inflation rate
𝑟 ∶ Real interest rate removes inflation
▪ Example: If inflation f=3% and the real interest rate r=5%:
(1 + 𝑖) = (1.03)(1.05) = 1.0815 ⇒ 𝑖 = 8.15%
❖ Present Worth (PW) Calculations Adjusted for Inflation
▪ Present Worth (PW) tells us the current value of future cash flows
considering the time value of money and inflation.
▪ Nominal Analysis:
Use inflated cash flows and nominal interest rate.
𝑛
𝐶𝐹𝑡𝑛𝑜𝑚𝑖𝑛𝑎𝑙
𝑃𝑊 =
1−𝑖 𝑡
𝑡=1
❖ Present Worth (PW) Calculations Adjusted for Inflation
Example (Nominal PW):
A machine saves $10,000 annually (with 2% inflation expected), for 3 years.
Nominal discount rate is 8%.
Annual savings increase each year:
Year 1: $10,000
Year 2: $10,200
Year 3: $10,404
10,000 10,200
𝑃𝑊 = + 2
+⋯
1.08 1.08
❖ Present Worth (PW) Calculations Adjusted for Inflation
▪ Real Analysis:
Use constant cash flows and real interest rate.
𝐶𝐹𝑡𝑟𝑒𝑎𝑙
𝑛
σ𝑡=1
𝑃𝑊 =
1+𝑟 𝑡
Example (Real PW):
▪ Use constant $10,000 savings and real interest rate of:
1.08
𝑟= − 1 ≈ 5.88
1.02
Then use this real interest to calculate PW will be the real PW.
❖ Capital Recovery (CR) Calculations Adjusted for Inflation
▪ Capital Recovery (CR) converts an initial investment into equivalent
annual payments
▪ We may calculate it including interest and inflation effects.
❖ Capital Recovery (CR) Calculations Adjusted for Inflation
▪ Nominal Approach: Use nominal interest rate and nominal investment.
𝑖 1+𝑖 𝑛
𝐶𝑅 = 𝑃 ⋅
1+𝑖 𝑛−1
▪ Example: Initial cost = $50,000, Nominal rate = 10%, life = 5 years
0.10 1.10 5
𝐶𝑅 = 50,000 ⋅ 5
≈ 13,187
1.10 − 1
This means $13,187 per year (in inflated dollars) covers the investment
over 5 years.
❖ Capital Recovery (CR) Calculations Adjusted for Inflation
▪ Real Approach: Use real rate and real (constant) dollars.
Assume real rate = 6.8%
0.068 1.068 5
𝐶𝑅 = 50,000 ⋅ 5
≈ 12,232
1.068 − 1
❖ Conclusion
• Inflation must be included in analysis for accuracy.
• Always be consistent in nominal/real framework.
• Real rates are best for long-term decisions when inflation is uncertain.
• Present and Future Worth methods help compare project alternatives.
