Engineering Economics

Chapter 14
Effects of inflation
Students Names
Cyrine Qaraqe /20190723/
Salah Boubes /20180157/
Hamza Boubes /20171585/
Mohammed Fayeq /20216522/

Supervisor Dactor
Dr. Mais Alzghool
Learning Outcomes
 1. Understand inflation/deflation.

 2. Calculate PW of cash flows with inflation.

 3. Calculate FW taking inflation into account.

 4. Calculate AW taking inflation into account.

Understand inflation/deflation
We are all very well aware that $20 now does not purchase the same amount as
$20 did in 2005 and purchases significantly less than in 2000. Why? Primarily this
is due to inflation and the purchasing power of money.

Inflation: is an increase in the amount of money necessary to obtain the same

amount of goods or services before the inflated price was present.

Purchasing power , or buying power , measures the value of a currency in terms

of the quantity and quality of goods or services that one unit of money will
purchase.

 Inflation decreases the purchasing ability of money in that less goods or

services can be purchased for the same one unit of money.
 To make comparisons between monetary amounts that occur in different time
periods, the different-valued money first must be converted to constant-value
money in order to represent the same purchasing power over time.

Money in one period of time t1 can be brought to the same value as money in
another period of time t2 by using the equation:

amount in period t2
 Amount in period t1 =
inflation rate between t1 and t2

 Using dollars as the currency, dollars in period t1 are called constant-value dollars
or today’s dollars. Dollars in period t2 are called future dollars or then-current
dollars and have inflation taken into account. If f represents the inflation rate per
period (year) and n is the number of time periods (years) between t1 and t2, the
equation will be:

future dollars
 Constant-value dollars =
(1+ f )n

 Future dollars = constant-value dollars (1+ f )n

Types of rates that relate to understand the inflation
 Real or inflation-free interest rate i: representing the gain in purchasing
power when inflation effects are excluded. Individuals typically experience a
3.5% annual real rate, considered a safe investment. However, corporations
and some individuals may set a higher required real rate when establishing a
minimum acceptable rate of return without adjusting for inflation.

 Inflation-adjusted or market interest rate if : which combines the real

interest rate and inflation rate.

𝒊𝒇 = 𝒊 + 𝒇 + (𝒊)(𝒇)

 Inflation rate f : As described above, this is a measure of the rate of change

in the value of the currency.
 Deflation
 Deflation: Deflation, opposite to inflation, increases the future purchasing power of
money. Fewer dollars will be needed in the future to buy the same goods or
services. While inflation is more common, in deflation, the market interest rate is
consistently lower than the real interest rate.

Temporary price deflation can occur in specific economic sectors due to factors like
improved products or cheaper technology. This might lead to a short-term adjustment
in prices, but in normal situations, prices stabilize competitively. Deflation in a sector
can be orchestrated through dumping, as seen in the importation of materials at low
prices, impacting domestic manufacturers and potentially leading to inflation over
time. While moderate deflation may seem beneficial after prolonged inflation,
national-level deflation can lead to insufficient funds for new capital, reduced
spending capacity for individuals, and a generally tighter financial environment due to
fewer jobs, limited credit and fewer loans available; an overall “tighter” money
situation prevails.
Example: Constant Value Dollars
How much would be required to purchase an item that increased in cost by
exactly the inflation rate? The cost 30 years ago was $100 and inflation has
consistently averaged 4% per year.

Solution: Sole for future dollars

𝑛 30
𝐹𝑢𝑡𝑢𝑟𝑒 𝐷𝑜𝑙𝑙𝑎𝑟𝑠 = 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 1 + 𝑓 = 1000 1 + 0.04 = $3243

NOTE: This calculation only account for the decreased purchasing power of the
currency. It dose not take into account the time value of money (to be
discussed).
Example: Market VS. Real Rate
Money in a medium-risk investment makes a guaranteed 8% per year. Inflation
rate has averaged 5.5% per tear. What is the real rate of return on the
investment?

Solution: Solve for the real rate i in relation if

𝑖𝑓 = 𝑖 + 𝑓 − 𝑖 (𝑓)

𝑖𝑓 − 𝑓
𝑖=
1+𝑓

0.08 − 0.055
𝑖= = 0.024 = 2.4%
1 + 0.055

Investment pays only 2.4% per year in real terms VS. the stated 8%
Present Worth Calculations Adjusted for
Inflation
Present Worth Calculations adjusted for inflation involve accounting for changes in
the value of currency over time. When determining the present worth of future cash
flows, it's crucial to consider the impact of inflation. This is typically done by
discounting future cash flows at a rate that reflects both the real interest rate
(adjusted for inflation) and the expected inflation rate. Adjusting for inflation
ensures a more accurate assessment of the actual purchasing power and value of
money over the investment period.
Present Worth Calculations Adjusted
for Inflation
1
P = 𝐹 (1+𝑖)𝑛

𝑖𝑓 = 𝑖 + 𝑓 + 𝑖 ∗ 𝑓
𝑖𝑓 : inflation-adjusted or market interest rate
𝑖 : real interest rate
f : inflation rate

Present Worth Calculation Using an Inflated Interest Rate is

1
P = 𝐹 (1+𝑖 𝑛 = F(P/F, 𝑖𝑓 ,n)
𝑓)
Present Worth Calculations Adjusted for
Inflation
 If we have an item has a cost 5000 $ today, we will calculate the actual cost of
the item 4 years from now when the costs are increasing by an amount exactly
equal to the inflation rate (4%).And we will calculate the present worth of
future amounts of $5000 at a real interest rate of 10% per year.

Year (n) Cost Cost in Present

Increase Future Worth at
due to 4% Dollars, $ Real i
Inflation, $ 10%,$
0 0 5000 5000
1 200 5200 4545
2 208 5408 4123
3 216 5624 3757
4 225 5849 3415
Present Worth Calculations Adjusted
for Inflation
𝑖𝑓 = 0.10 + 0.04 + 0.10(0.04) = 0.144

P = F(P/F, 𝑖𝑓 ,n) = 5200(P/F, 14.4% ,1) = 4545 $

 If a cash flow series is expressed in today’s (constant-value) dollars, then its PW is

the discounted value using the real interest rate 𝑖 .

 If the cash flow is expressed in future dollars, the PW value is obtained using 𝑖𝑓 .
Present Worth Calculations Adjusted
for Inflation
 A 15-year $50,000 bond that has a dividend rate of 10% per year, payable
semiannually, is currently for sale. If the expected rate of return of the
purchaser is 8% per year, compounded semiannually, and if the inflation rate
is expected to be 2.5% each 6-month period, what is the bond worth now:
(a) without an adjustment for inflation?
(b) when inflation is considered?
Present Worth Calculations Adjusted
for Inflation
(a) Without inflation adjustment: The semiannual dividend is
A = [(50,000)(0.10)]/2 = $2500.
At a nominal 4% per 6 months for 30 periods,
PW = 2500(P/A,4%,30) + 50,000(P/F,4%,30) = $58,645

(b) With inflation: Use the inflated rate 𝑖𝑓 .

𝑖𝑓 = 0.04 + 0.025 + (0.04)(0.025) = 0.066 per semiannual period
PW = 2500(P/A,6.6%,30) + 50,000(P/F,6.6%,30)
= 2500(12.9244) + 50,000(0.1470) = $39,660
Future Worth Calculations Adjusted for
Inflation
Calculating future worth adjusted for inflation involves considering how the
purchasing power of money changes over time. Essentially, it's about figuring out
the future value of money in today's terms.

Here's a simplified explanation:

"When you calculate future worth adjusted for inflation, you're accounting for
how the value of money changes over time. This means determining what a
certain amount of money in the future is really worth in today's terms,
considering the impact of inflation on its purchasing power."
 Case 1: Actual Amount Accumulated It should be clear that F, the actual amount of money
accumulated, is obtained using the inflation-adjusted (market) interest rate.
𝑛
𝐹 = 𝑃 1 + 𝑖𝑓 = 𝑃(𝑓/𝑃, 𝑖𝑓 , 𝑛)

 Case 2: Constant-Value Dollars with Purchasing Power The purchasing power of future
dollars is determined by first using the market rate i f to calculate F and then deflating the
future amount through division by 1 + 𝑓 𝑛

𝑛
𝑃 1 + 𝐼𝑓 𝑃(𝐹/𝑝, 𝑖𝑓 , 𝑛) 𝑖𝑓 − 𝑓
𝐹= = , 𝑊ℎ𝑒𝑛 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖 =
1+𝑓 𝑛 1+𝑓 𝑛 1+𝑓

 Case 3: Future Amount Required, No Interest This case recognizes that prices increase
when inflation is present. Simply put, future dollars are worth less, so more are needed. No
interest rate is considered in this case—only inflation.
𝑛
𝐹 =𝑃 1+𝑓 = 𝑃(𝐹/𝑃, 𝑓, 𝑛)

 Case 4: Inflation and Real Interest This is the case applied when a market MARR is
established. Maintaining purchasing power and earning interest must account for both
increasing prices (case 3) and the time value of money. If the growth of capital is to keep up,
funds must grow at a rate equal to or above the real interest rate i plus the inflation rate f.
 FW Calculations with Inflation
 The actual amount accumulated

 Use if in FW equation FW = PW(F/P,if,n)

 The purchasing power in terms of CV dollars of the future amount

 Use if in FW equation and divided by (1+f)n

or use real i where real i = (if – f)/(1 + f) FW = PW(F/P,i,n)

 The number of future dollars required to have same purchasing power as a dollar
today with no time value of money considered

 Use f instead of i in F/P factor FW = PW(F/P,f,n)

 The amount required to maintain the purchasing power of the present sum and
earn a stated real rate of return

 Use if in FW equation FW = PW(F/P,if,n)

Example: FW with Inflation
 engineer invests $15,000 in a savings account that pays interest at a real 8%
per year. If the inflation rate is 5% per year, determine (a) the amount of
money that will be accumulated in 10 years, (b) the purchasing power of the
accumulated amount (in terms of today's dollars), (c) the number of future
dollars that will have the same purchasing power as the $15,000 today, and
(d) the amount to maintain purchasing power and earn a real 8% per year
return.

 Solution:

(a) The amount accumulated is as function of the market interest rate, if

if = 0.08 + 0.05 + (0.08)(0.05) = 13.4%

Amount Accumulated = 15,000(F/P,13.4%,10) = $52,750

(b) To find the purchasing power of the accumulated amount deflate the inflated
dollars

Purchasing power = 15,000(F/P,13.4%,10) / (1+0.05)10 = $32,384

(c) The number of future dollars required to purchase goods that cost $15,000
now is the inflated cost of the goods

Number of future dollars = 15,000(F/P,5%,10) = $24,434

(d) In order to maintain purchase power and earn a real return, money must grow
by the inflation rate and the interest rate, or if = 13.4%, as in part (a)

FW = 15,000(F/P,13.4,10) = $52,750
Capital Recovery Calculations
Adjusted for Inflation
 It is particularly important in capital recovery (CR) calculations used for AW
analysis to include inflation because current capital dollars must be recovered
with future inflated dollars. Since future dollars have less buying power than
today’s dollars, it is obvious that more dollars will be required to recover the
present investment

 The A/P and A/F factors require the use of if when inflation is considered.
Example: AW with Inflation
 If a small company invests $150,000 in a new production line machine, how
much must it receive each year to recover the investment in 5 years? The real
interest rate is 10% and the inflation rate is 4% per year.

 Solution: Capital recovery CR is the AW value

if = 0.10 + 0.04 + (0.10)(0.04) = 14.4%

CR = AW = 150,000(A/P,14.4%,5) = $44,115 per year