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8/17/2019 Lecture No45
1/19
Contemporary EngineeringEconomics, 4th edition, © 2007
Efects o Inationon Project CashFlows
Lecture No. 45
Chapter 11
Contemporary Engineering Economics
Copyright © 2006
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Efects o Ination on Projects with Depreciable Assets
Item Effects of Inflation
epreciation e!pense
"al#age #alue
epreciation e!pense is charge$ tota!a%le income in $ollars of $eclining
#alues& ta!a%le income is o#erstate$'resulting in higher ta!es
Inflate$ sal#age #alue com%ine$ (ith%oo) #alues %ase$ on historical costs
results in higher ta!a%le gains.
Note: Depreciation expenses are based on historical costs and
always expressed in actual dollars
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Example 11.8
*econsi$er the +utomate$ ,achining Center pro-ect$iscusse$ earlier. hat (ill happen to thisin#estment pro-ect if
the general inflation $uring the ne!t fi#e years is e!pecte$to increase %y 5/ annually' sales' operating costs' an$ (or)ing capital reuirements
are assume$ to increase accor$ingly' $epreciation (ill remain unchange$' %ut ta!es' profits' an$
thus cash flo( (ill %e higher. the firms inflationfree interest rate is )no(n to %e 15/.
etermine the 3 of the pro-ect.
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Example 11.8 Excel
or!sheet
epreciation $e$uction$oes not increase o#er time to )eep pace (ithinflation.
N3 7'788 9 0
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Item Effects of Inflation
Loan
repayments
:orro(ers repay historical
loan amounts (ith $ollars of$ecrease$ purchasing po(er're$ucing the $e%tfinancingcost.
Efects o "orrowe# F$n#s$n#er Ination
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Contemporary EngineeringEconomics, 4th edition, © 2007
Example 11.1% Efects o Ination onPa&ments with Financin'
;he $e%t paymentsi
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Item Effects of Inflation
*ate of *eturn
an$ N3
=nless re#enues are
sufficiently increase$ to )eeppace (ith inflation' ta! effectsan$>or a (or)ing capital $rainresult in lo(er rate of return orlo(er N3.
Efects o Ination on (et$rnon In)estment
8/17/2019 Lecture No45
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Contemporary EngineeringEconomics, 4th edition, © 2007
(ate o ret$rn Calc$lation inthe Absence o Ination
I** 21.77/
;he in#estment
is accepta%le.
,+** 20/
8/17/2019 Lecture No45
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Contemporary EngineeringEconomics, 4th edition, © 2007
(ate o (et$rn Calc$lation$n#er Ination
I** 18.40/
;he in#estment
is no longeraccepta%le.
,+** 20/
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(ate o (et$rn Anal&sis $n#erInation 3rinciple?;rue @realA rate of
return shoul$ %e %ase$ onconstant $ollars.
If the rate of return is
compute$ %ase$ on actual$ollars' the real rate ofreturn can %e calculate$ as?
n
Net cashflo(s inactual$ollars
Net cashflo(s inconstant$ollars
01
2
4
0'0001'5B0
15'760
1'57
1'626
0'00012'6
1'107
10'06
8'0B
IRR 31.34% 19.40%i
i
'
.
.
.40%
_ =
+
+
−
=+
+
−
=
1
11
1 0 3134
1 0 101
19 Not correct IRR
_
= 10%
8/17/2019 Lecture No45
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Contemporary EngineeringEconomics, 4th edition, © 2007
Decision Criterion
If you use 1.4/ as your I**' you shoul$use a mar)et interest rate @or inflationa$-uste$ ,+**A to ma)e an accept an$
re-ect $ecision. If you use 18.40/ as your I**' you shoul$
use an inflationfree interest rate @inflation
free ,+**A to ma)e an accept an$ re-ect$ecision. In our e!ample' ,+** 20/.
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Item Effects of Inflation
or)ing capital
reuirement
no(n as (or)ing capital
$rain' the cost of (or)ingcapital increases in aninflationary en#ironment.
Efects o Ination on or!in' Capital
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Example 11.1* +a, itho$tInation
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Example 11.1* +b, ithInation
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or!in' Capital(e-$irements $n#er
Ination
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$mmar&
;he Consumer Price Index (CPI) is a statisticalmeasure of change' o#er time' of the prices ofgoo$s an$ ser#ices in ma-or e!pen$iture groupsDsuch as foo$' housing' apparel' transportation'
an$ me$ical careDtypically purchase$ %y ur%anconsumers. Inflation is the term use$ to $escri%e a decline
in purchasing power e#i$ence$ in an economicen#ironment of rising prices.
Deflation is the opposite? +n increase inpurchasing po(er e#i$ence$ %y falling prices.
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;he general inflation rate @f A is an a#erageinflation rate %ase$ on the C3I. +n annual
general inflation rate @ A can %e calculate$ usingthe follo(ing euation?
"pecific' in$i#i$ual commo$ities $o not al(aysreflect the general inflation rate in their pricechanges. e can calculate an average inflation
rate for a specific commo$ity @ j A if (e ha#e anin$e! @that is' a recor$ of historical costsA for thatcommo$ity.
!"I !"I
!"I n
n n
n
=
−−
−
1
1
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Contemporary EngineeringEconomics, 4th edition, © 2007
3ro-ect cash flo(s may %e state$ in one of t(oforms
Actual dollars ( An): ollars that reflect theinflation or $eflation rate.
Constant dollars ( A’ n): ear 0 $ollars Interest rates for pro-ect e#aluation may %e
state$ in one of t(o forms?
Market interest rate (i ): + rate (hich com%inesthe effects of interest an$ inflation& use$ (ithactual dollar analysis
Inflationfree interest rate (i’ ): + rate from(hich the effects of inflation ha#e %een remo#e$&this rate is use$ (ith constant $ollar analysis
8/17/2019 Lecture No45
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;o calculate the present (orth of actual $ollars'
(e can use a t(ostep or a onestep process?Deflation method!two steps:
1. Con#ert actual $ollars %y $eflating (ith thegeneral inflation rate of
2. Calculate the 3 of constant $ollars %y$iscounting at i’
Ad"usteddiscount method!one step
1. Compute the mar)et interest rate.
2. =se the mar)et interest rate $irectly to fin$the present #alue.