Lecture # 3 Compounding Factors - Effects of Inflation

Lecture # 3
1. Compounding Factors 2. Effect of Inflation
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Dr. A. Alim
Determination of Unknown Interest Rate

Class of problems where the interest rate, i%, is the unknown value For simple, single payment problems (i.e., P and F only), solving for i% given the other parameters is not difficult For annuity and gradient type problems, solving for i% can be tedious
Trial and error method Use EXCEL
Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012
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2012 by McGraw-Hill, New York, N.Y All Rights Reserved
The IRR and RATE Spreadsheet Functions

Define the total cash flow as a column of values within Excel Apply the IRR function:
=IRR(first_cell:last_cell, guess value)
If the cash flow series is an A value then apply the RATE function:
=RATE(number_years, A,P,F)
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The IRR and RATE Spreadsheet Functions

Example 1 End of Year Cash Flow 0 1 2 3 4 $ (1,200.00) $ 354.00 $ 700.00 $ 216.00 $ 953.00
IRR =
26.3%
Example 2 End of Year Cash Flow 0 1 2 3 4 $ (1,200.00) $ 400.00 $ 400.00 $ 400.00 $ 400.00
Rate = IRR =
12.6% 12.6%
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Determination of Unknown Number of Years

Class of problems where the number of time periods (years) is the unknown In single payment type problems, solving for n is straight forward In other types of cash flow profiles, solving for n requires trial and error. In Excel, given A, P, or F, and i% values apply:
=NPER(i%,A,P,F) to return the value of n
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Determination of Unknown Number of Years
Example: P A i -1200 400 12.60% 4
Number of periods =
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Interest rates that vary over time

In practice interest rates do not stay the same over time unless by contractual obligation.
There can exist variation of interest rates over time quite normal!
If required, how do we handle that situation?
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Interest Rates that vary over time

Best illustrated by an example.
Assume for now that interest rate is constant 7% for the whole 4 years period:
$70,000 $70,000 $35,000 7% 0 1 7% 2 7% 3 7% 4 $25,000
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$70,000 $70,000 $35,000 7% 0
P=
$25,000 7%
7% 1 2
7% 3
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$70,000 $70,000 $35,000 7% 0 1 7% 2 7% 3 7% 4 $25,000
P = 70,000(P/A,7%,2) + 35,000(P/F,7%,3) + 25,000(P/F,7%,4)
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Now, assume the following future profits:

$70,000 $70,000 $35,000 7% 0 1
(P/F,7%,1) (P/F,7%,1) (P/F,7%,1) (P/F,9%,1) (P/F,9%,1) (P/F,10%,1)
$25,000 10%
7% 2
9% 3
(P/F,7%,1) (P/F,7%,1) (P/F,7%,1) (P/F,7%,1)
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Varying Rates: Present Worth

To find the Present Worth:
Bring each cash flow amount back to the appropriate point in time at the interest rate according to: P = F1(P/F,i1,1) + F2(P/F,i1,1)(P/F,i2,1) + + Fn(P/F,i1,1)(P/F,i2,1)(P/F,i3,1)(P/F,in,1)
This Process can get computationally involved!
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Period-by-Period Analysis
P0 =
$7000(P/F,7%,1) +
$7000(P/F,7%,1)(P/F,7%,1) + $35000(P/F,9%,1)(P/F,7%,1)2 + $25000(P/F,10%,1)(P/F,9%,1)(P/F,7%,1)2
Equals: $172,816 at t = 0
Work backwards one period at a time until you get to 0.

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To obtain the equivalent uniform series A over all n years, substitute the symbol A for each Fi, then solve for A:
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P0 = $172,816 =
$A (P/F,7%,1) + $A (P/F,7%,1)(P/F,7%,1) + $A (P/F,9%,1)(P/F,7%,1)2 + $A (P/F,10%,1)(P/F,9%,1)(P/F,7%,1)2
Solve for A = $51,777 per year

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Varying Rates: Approximation

An alternative approach that approximates the present value:
Average the interest rates over the appropriate number of time periods. In the previous example {7% + 7% + 9% + 10%} / 4 = 8.25% This approach is only an approximation. Students MUST NOT use this method in solving problems in quizzes or examinations.
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Inflation - Definition
The increase in the amount of money necessary to obtain the same amount of product or service before the inflated price was present; Social Phenomena where too much money chases too few goods/services; Harmful impact because the purchasing power of the currency changes downward in value.
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Deflation
Where the value , i.e. the purchasing power of the currency increases over time. Less amounts of the currency can purchase more goods and services than before. Not very commonly seen2009 was the first year with deflation (or zero inflation) in a very long time!
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Inflation rate - f
The measure of the annual rate of change in the value of a currency. Similar to an interest rate but should not be viewed as an interest rate. f is a percentage value similar to the interest rate. Let n represent the period of time between now and a future date, then: Future cost = Current cost (1 +f )n Note: this does not involve time value of money (compounding)
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Example to Consider
Assume a firm desires to purchase a productive asset that costs $209,000 in todays dollars. Assume an inflation rate of say, 4% per year; In 10 years, that same piece of equipment would cost:
$209,000(1.04)10 = $309,371!
Does not include an interest rate or rate of return
consideration. The $309,371 are called future dollars.

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Inflation can be Significant

From the previous example we see that even at a modest 4% rate of inflation, the future impact on cost can be and often is significant! The previous example does not consider the time value of money. A proper engineering economy analysis should consider both inflation and the time value of money.
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How is inflation measured*?

Consumer Price Index (CPI) - a government measure of the price change of a market basket of goods and services (national inflation rate)
Producer Price Indices a government measure of price changes for specific industries

Chemical and Petrochemical Process Plants Farm Products Consulting Engineering Services Price Indexes Residential Building Construction Input Price Indexes Industrial product price indexes Raw materials price indexes Energy consumer price indices
* Ref. : J.C. Paradi, Centre for Management of Technology and Entrepreneurship ( 1996-2004)
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CPI
The CPI for a given period relates the average price of a fixed basket of goods in the given period to the average price of the same basket of goods in a base period.
Current CPI base year is 1982 -84.

Base year index is set at 100. The index for any other year indicates the number of dollars needed in that year to buy the basket of goods that cost $100 in 1982-84.
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Historical CPI
Consumer Price Index historical summary 1982-84 = 100%
Year CPI % Change Year CPI % Change Year CPI % Change
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982
41.8 44.4 49.3 53.8 56.9 60.6 65.2 72.6 82.4 90.9 96.5
3.2 6.2 11.0 9.1 5.8 6.5 7.6 11.3 13.5 10.3 6.2
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
99.6 103.9 107.6 109.6 113.6 118.3 124.0 130.7 136.2 140.3 144.5
3.2 4.3 3.6 1.9 3.6 4.1 4.8 5.4 4.2 3.0 3.0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
148.2 152.4 156.9 160.5 163.0 166.6 172.2 177.1 179.9 184.0 188.9 195.3 201.6 207.3 215.3 214.5 218.1 224.9 230.0
2.6 2.8 3.0 2.3 1.6 2.2 3.4 2.8 1.6 2.3 2.7 3.4 3.2 2.9 3.8 -0.4 1.7 3.2 2.2
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Inflation rate - f
Defined as the percent change in CPI from year to year. For example, from the previous table: CPI in 2009 is 214.5 CPI in 2010 is 218.1
Inflation rate in 2010 is: 100 x (218.1 214.4)/214.5 = approx 1.7%

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Annual Inflation rate
CPI
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Accounting for inflation

There are two ways to make meaningful economic calculations when the currency is changing in value, that is when inflation is considered: 1. Convert the amounts that occur in different time periods into constant value dollars. This is accomplished before any time value of money calculation is made using the real interest rate. 2. Change the interest rate used to account for inflation plus the time value of money. This is called the inflation-adjusted or market interest rate.
2012 by McGraw-Hill, New York, N.Y All Rights Reserved 28
1) Constant value dollars vs. future dollars Future Dollars = Todays dollars(1+f)n
Dollars at present time are termed:
Constant-value or todays dollars
Dollars in time period t are termed:

Future Dollars or, Then-current Dollars.
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Critical Relationships to Remember
Constant-value Dollars (Todays dollars)
future dollars Constant-Value dollars = n (1+f)

Future Dollars
Future dollars = today's dollars(1+f) .

2012 by McGraw-Hill, New York, N.Y All Rights Reserved 30
2) Adjusting interest rate to include inflation

Three Important Rates
Inflation-free interest rate.

Denoted as i.
Inflation-adjusted interest rate.

Denoted as if
Inflation rate.
Denoted as f.
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Real or Inflation-free Interest Rate - i
Rate at which interest is earned. Effects of any inflation have been removed. Represents the actual or real gain received/charged on investments or borrowing.
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Inflation-adjusted rate if
The interest rate that has been adjusted to include inflation.

Common Term
Market Interest Rate. Interest rate adjusted for inflation.
The if rate is the combination of the real interest rate i, and the inflation rate f. Also called the inflated interest rate.
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Defining if
if
is derived from f and i as follows:
if = (i + f + if )
Or:
i
if f 1 f
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Example
Assume i = 10%/ year; f = 4% per year; if is then calculated as:

if = 0.10 + 0.04 + 0.10(0.04) = 0.144 = 14.4%/year
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Which interest rate to use?

Either rate is correct when the correct dollar value is selected:
Cash flow in Interest rate to use
Todays dollar (constant value)

Future dollars
i
if
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Example 14.1, Blank (6th ed.), page 477
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Effect of Inflation on the MARR

When inflation is expected during the life of a project, the MARR needs to be increased to avoid accepting poor projects.
Inflated MARR = minimum acceptable rate of return when cash
flows are in actual dollars (future dollars).
If investors expect inflation, they require higher actual rates of return on their investments than if inflation were not expected.
Inflated MARR = real MARR (without inflation) + upwards
adjustment which reflects the effect of inflation.
So, following from the definition, we have: if = (i + f + if ) MARRinflated = MARRR + f + MARRR * f

(without inflation).
where MARRinflated(if) is inflated MARR and MARRR (i) is real MARR
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Example 14.4, Blank (6th ed.), page 483: Abbott Mining Systems wants to determine whether it should buy now or buy later a piece of equipment used in deep mining operations. If the company selects plan N, the equipment will be purchased now for $200,000. However, if the company selects plan L, the purchase will be deferred for 3 years when the cost is expected to rise rapidly to $340,000. Abbott is ambitious; it expects a real MARR of 12% per year. The inflation rate in the country has averaged 6.75% per year. From only an economic perspective, determine whether the company should purchase now or later (a) when inflation is not considered and (b) when inflation is considered. Solution a) Inflation not considered: The real rate, or MARR, is i = 12% per year. The cost of plan L is $340,000 three years hence. Calculate the FW value for plan N three years from now: FWN = -200,000(F/P,12%,3) = $-280,986 FWL = $-340,000 Hence buy now
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b) Inflation considered: There is a real rate (12%), and inflation is 6.75%. First, compute the inflation-adjusted MARR :
MARRf = 0.12 + 0.0675 + 0.12(0.0675) = 0.1956 Compute the FW value for plan N in future dollars. FWN = -200,000(F/P,19.56%,3) = $-341,812 FWL = $-340,000 Purchasing later is selected, because it requires fewer equivalent future dollars. The inflation rate of 6.75% per year has raised the equivalent future worth of costs by 21.6% to $341,812.
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Lecture # 3 Compounding Factors - Effects of Inflation

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Lecture # 3

1. Compounding Factors 2. Effect of Inflation

Determination of Unknown Interest Rate

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

The IRR and RATE Spreadsheet Functions

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

The IRR and RATE Spreadsheet Functions

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Determination of Unknown Number of Years

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Determination of Unknown Number of Years

Example: P A i -1200 400 12.60% 4

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Interest rates that vary over time

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Interest Rates that vary over time

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Interest Rates that vary over time

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Interest Rates that vary over time

P = 70,000(P/A,7%,2) + 35,000(P/F,7%,3) + 25,000(P/F,7%,4)

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Interest Rates that vary over time

Now, assume the following future profits:

(P/F,7%,1) (P/F,7%,1) (P/F,7%,1) (P/F,7%,1)

Varying Rates: Present Worth

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Work backwards one period at a time until you get to 0.

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

$A (P/F,7%,1) + $A (P/F,7%,1)(P/F,7%,1) + $A (P/F,9%,1)(P/F,7%,1)2 + $A (P/F,10%,1)(P/F,9%,1)(P/F,7%,1)2

Solve for A = $51,777 per year

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Varying Rates: Approximation

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Does not include an interest rate or rate of return

consideration. The $309,371 are called future dollars.

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Inflation can be Significant

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

How is inflation measured*?

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Current CPI base year is 1982 -84.

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Inflation rate in 2010 is: 100 x (218.1 214.4)/214.5 = approx 1.7%

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Annual Inflation rate

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Accounting for inflation

Dollars in time period t are termed:

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Critical Relationships to Remember

Constant-value Dollars (Todays dollars)

future dollars Constant-Value dollars = n (1+f)

Future dollars = today's dollars(1+f) .

2) Adjusting interest rate to include inflation

Inflation-free interest rate.

Inflation-adjusted interest rate.

2012 by McGraw-Hill, New York, N.Y All Rights Reserved