Engineering Economic Analysis

FOURTEENTH EDITION

Donald G. Newnan
Chapter 14 San Jose State University

Inflation & Price

Ted G. Eschenbach
University of Alaska Anchorage

Change Jerome P. Lavelle

North Carolina State University

Neal A. Lewis
Fairfield University

Copyright Oxford University Press 2020 14-1

Chapter Outline

◼ Meaning & Effect of Inflation

◼ Analysis in Constant Dollars versus Then-Current
Dollars
◼ Price Change with Indexes
◼ Cash Flows that Inflate at Different Rates
◼ Different Inflation Rates per Period
◼ Inflation Effect on After-Tax Calculations
◼ Using Spreadsheets for Inflation Calculations

Copyright Oxford University Press 2020 14-2

Learning Objectives

◼ Describe inflation & its effects

◼ Define real & actual dollars & interest rates
◼ Conduct constant dollar & nominal dollar analyses
◼ Use composite & commodity-specific price indexes
◼ Develop cash flows with different inflation rates
◼ Use inflation in before- & after-tax calculations
◼ Use spreadsheets to incorporate inflation & price
change

Copyright Oxford University Press 2020 14-3

Vignette: Price Trends
in Solar Technologies

◼ Price of solar power is decreasing

◼ In contrast to fossil fuels, cost of electricity based on
infrastructure costs, not natural resource cost
◼ To be fully competitive, cost needs to be reduced by 75%
compared to 2010 prices
◼ Adoption of solar power increased tenfold since 2008
◼ Prices for photovoltaic systems decreased 6-12% between
1998 & 2014
◼ Deployment of solar continues in spite of 2015 oil price
decrease
◼ Solar is 3rd most added electricity generation capacity
after wind & natural gas
Copyright Oxford University Press 2020 14-4
Vignette: Price Trends
in Solar Technologies

◼ Deflation decreases general prices. How does this differ

from decreasing price of solar power?
◼ Most U.S. electricity generation is from fossil fuels. How
has 2015 decline in oil prices affected solar power
adoption?
◼ Compare price changes for wind, solar, & geothermal over
last 5 years. Which declined the most?
◼ Besides cost what are other barriers to photovoltaic
adoptions?

Copyright Oxford University Press 2020 14-5

Meaning & Effect of Inflation

◼ Inflation causes money to lose purchasing power

◼ Inflation makes future dollars less valuable than
present dollars
◼ Deflation occurs when the purchasing power
increases
◼ Example: price of gasoline decreases; $20 will buy more
gasoline

Copyright Oxford University Press 2020 14-6

How Does Inflation Happen?

◼ Money supply: money available to consumers increases

faster than goods available
◼ Exchange rates: prices change to reflect value of
currencies in different countries
◼ Cost-push: producers raise prices to cover costs
◼ Demand-pull: consumers willing to pay more for goods &
services & suppliers can raise prices

Copyright Oxford University Press 2020 14-7

Inflation Definitions

◼ Inflation rate (f ): annual rate of increase in number of

dollars needed to pay for same amount of goods or
services
◼ Real interest rate (i′): real value of money excluding
inflation
◼ Market interest rate (i) interest rate in general
marketplace; includes both real interest & inflation
(1 + i) = (1 + i′)(1 + f )

i = i′ + f +(i′)(f ) (14-1)

Copyright Oxford University Press 2020 14-8

Example 14-1
Real Interest Rate Calculation

Bank pays 5.5% compounded annually; inflation = 2%/yr.

Identify i, f, & i’.

i = 5.5%; f = 2%
i = i′ + f + i′f
i – f = i′ (1 + f )
i′ = (i – f )/(1 + f ) = (0.055 – 0.02)/(1 + 0.02) = 0.034 = 3.4%

for f = 8%
i′ = (i – f )/(1 + f ) = (0.055 – 0.08)/(1 + 0.08) = –0.023 = – 2.3%

Copyright Oxford University Press 2020 14-9

Actual Dollars & Real Dollars
Definitions

◼ Actual dollars (A$): cash money; actual dollars in

circulation
◼ Real dollars (R$): constant value dollars having constant
purchasing power; inflation-free
◼ Use a market interest rate (i) when dealing with A$
◼ Use a real interest rate (i’) when dealing with R$

Copyright Oxford University Press 2020 14-10

Example 14-2
Real Interest Rate Calculation
Stadium completed in 1965 cost $1.2M. Gift of $1.2M given for a
future replacement. A new stadium is being considered for 2020.
Inflation = 6.0%/yr; gift invested at 8.0%/yr. Define i, i’, f, & A$.

f = 6.0%; i = 8.0%, A$ = $1.2M in 1965

i′ = (i – f )/(1 + f ) = (0.08 – 0.06)/(1.06) = 0.01887, or 1.877%

How many actual dollars is the gift will worth in 2020?

Actual dollars in 2020 = Actual dollars in 1965 (F/P,i,55)

$82,701,600 = $1.2M(F/P,8%,55)

Copyright Oxford University Press 2020 14-11

Example 14-2
Real Interest Rate Calculation
How much would A$ in 2020 be in terms of 1965 purchasing
power?

Real 1965 dollars in 2020 = (Actual 2020 dollars)(P/F,f,55)

= ($82,701,600)(P/F,f,55) = $3,357,700

How much better or worse should new stadium be?

This will build a stadium that

is nearly 3 times as nice!
Copyright Oxford University Press 2020 14-12
Example 14-3
Real Interest Rate Calculation
$1000 worth of quarters buried in backyard in 1924. Inflation
averaged 4.5% from 1924 to 1994. What purchasing power
of quarters relative to 1994?
The $1000 of quarters is still worth $1000 A$.
Real equivalent value in 1924 $s = 1000(P/F,4.5%,70) = $45.90

$1000 invested in stock market in 1924, worth how much in

1994? Stock market increased an average of 11.0%.

Actual dollars in 1994 = $1000(F/P,11.0%,70) = $1,488,000

Real 1924 dollars in 1994 = $1,488,000/(1 + f )70 = $68,307

Copyright Oxford University Press 2020 14-13

Example 14-3
Real Interest Rate Calculation

$1000 invested in government bonds in 1924, how much

will it be worth in 1994 given bonds averaged 6% return per
year?

Actual dollars in 1994 = $1000(F/P,6%,70) = $59,076

Real 1924 dollars in 1994 = $59,076/(1 + f )70 = $2712

Copyright Oxford University Press 2020 14-14

Inflation in Analysis

◼ If ignoring inflation in analysis

◼ Use real dollars (R$) & real interest rate (i’)
◼ Incorporating inflation in analysis
◼ Use actual dollars (A$) & market interest rates (i)

Copyright Oxford University Press 2020 14-15

Example 14-4
R$ Analysis versus A$ Analysis
Company Alpha: Cost = $150,000 in Yr 1, increasing 5%/yr
Company Beta: Cost = $150,000 / year
Constant dollar analysis

Company Alpha Beta

Year
0
1 150,000(1.05) =$150,000 150,000
1
2 150,000(1.05) = 157,500 150,000
2
3 150,000(1.05) = 165,375 150,000
3
4 150,000(1.05) = 173,644 150,000
4
5 150,000(1.05) = 182,326 150,000

Copyright Oxford University Press 2020 14-16

Example 14-4
R$ Analysis versus A$ Analysis
Company Alpha: Cost = $150,000 in Yr 1, increasing 5%/yr
Company Beta: Cost = $150,000 / year Constant dollar
analysis
Company Alpha Beta
Year
1
1 150,000/(1.035) =$144,928 150,000
2
2 157,500/(1.035) = 147,028 150,000
3
3 165,375/(1.035) = 149,159 150,000
4
4 173,644/(1.035) = 151,321 150,000
5
5 182,326/(1.035) = 153,514 150,000
i′ = (i – f )/(1 + f ) = (0.25 – 0.035)/(1.035) = 0.208, or 20.8%
Discounting all cash flows,
PW (Alpha) = $436,000, PW (Beta) = $441,000

Copyright Oxford University Press 2020 14-17

Example 14-4
R$ Analysis versus A$ Analysis
Then-Current Dollar Analysis:

Company Beta Company Alpha

Year R$ A$ A$
1 150,000 150,000(1.035)=$155,250 $150,000
2 1
2 150,000 150,000(1.035) =160,684 150,000(1.05) =157,500
3 2
3 150,000 150,000(1.035) =166,308 150,000(1.05) =165,375
4 3
4 150,000 150,000(1.035) =172,128 150,000(1.05) =173,644
5 4
5 150,000 150,000(1.035) =178,153 150,000(1.05) =182,326

Discounting all cash flows at MARR = 25%,

PW (Alpha) = $436,000, PW (Beta) = $441,000

Copyright Oxford University Press 2020 14-18

Example 14-5
R$ Analysis versus A$ Analysis
New heat exchanger costs $220,000, saves $50,000/yr; after 10
years, no salvage value. Real interest rate = 15%; inflation = 5%.
Is project worth doing? Analyze in A$ & R$.

i = i′ + f +(i′)(f )
= 0.15 + 0.05 + (0.15)(0.05)
= 0.2075

Both approaches yield

same result

Copyright Oxford University Press 2020 14-19

Price Change with Indexes

◼ Price indexes describe relative price fluctuations

of goods & services
◼ Price indexes track a specific commodity or
bundles of commodities
◼ Past price changes used to predict future prices
◼ All price indexes have a “base year,” assigned a
value of 100

Copyright Oxford University Press 2020 14-20

Price Changes in Postage
Table 14-1

◼ (Fictitious) Letter Cost Index describes relative

price fluctuation of sending first-class letter in
U.S.
◼ Base year = 1970. LCI1970 = 100

(14-2)

0.50
𝐿𝐶𝐼2018 = × 100 = 833
0.06

Copyright Oxford University Press 2020 14-21

Price Change with Indexes

◼ Annual percentage increase

𝐼𝑛𝑑𝑒𝑥𝑛 − 𝐼𝑛𝑑𝑒𝑥𝑛−1
𝐴𝑛𝑛𝑢𝑎𝑙 % 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑛 = × 100 (14-3)
𝐼𝑛𝑑𝑒𝑥𝑛−1

% change in LCI from 2012 to 2013

767 − 750
% 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒2013 = × 100 = 2.27%
750

Copyright Oxford University Press 2020 14-22

Example 14-6
Price Change with Indexes

A new building in LA cost $52.5M in 2016. How much

will a matching building cost in 2018?

California Construction Cost Index

CCCI2000 = 3746
CCCI2016 = 6106
F = P(1 + f )n F = 6106, P = 3746, n = 16
f = (6106/3746)1/16 – 1 = 3.10% per year

for 2018,
F = 52.5M x 1.03102 = $55.8 million in 2018

Copyright Oxford University Press 2020 14-23

Composite Cost Index:
Consumer Price Index (CPI)

CPI Inflation Rates (%)

Copyright Oxford University Press 2020 14-24

CPI index was 218.1 in 2010 & 237.0
in 2015.

What was CPI inflation rate over period?

A. 8.5%
B. 7.8%
C. 8.2%
D. I don’t know

Copyright Oxford University Press 2020 14-25

The average annual CPI was 218.4 in
2010, & 237.0 in 2015.

What is the CPI inflation rate over this

period?
A. 8.5%
B. 7.8% =(237.0 − 218.4)/218.4 = 0.078 = 7.8%
C. 8.2%
D. I don’t know

Copyright Oxford University Press 2020 14-26

Example 14-7 Cash Flows with
Different Inflation Rates

Develop utility cost

estimate

Utility costs & projected

cost increases in data
block

Note rows 16-33 are

hidden

Copyright Oxford University Press 2020 14-27

Example 14-8 What Market Rate to Earn Real
10% with Different Inflation Rates per Period

Year 1-5, Inflation rate = 5%, Real interest rate (i’) = 10%
i = i’ + f + i′f = 0.10 + 0.05 + (0.10)(0.05) = 0.1150 = 11.50%

Year 6-8, Inflation rate = 7.5%, Real interest rate = 10%

i = i’ + f + i′f = 0.10 + 0.075 + (0.10)(0.075) = 0.1825 = 18.25%

Year 9-13, Inflation rate = 3%, Real interest rate = 10%

i = i’ + f + i′f = 0.10 + 0.03 + (0.10)(0.03) = 0.1330 = 13.30%

Copyright Oxford University Press 2020 14-28

Example 14-9 Inflation Effect on
After-tax Calculation
$12K investment; no salvage value; n = 6 yrs.
Straight line depreciation, 28% tax rate. Find before- & after-
tax returns. a) Inflation rate = 0%; benefit = $2918/yr
b) Inflation rate = 5% for benefit
No 5% 5%
Annual
Year Inflation Inflation Inflation
Benefit
Actual $ factor Actual $
1 $2918 $2918 1.051 $3064
2 2918 2918 1.052 3217
3 2918 2918 1.053 3378
4 2918 2918 1.054 3547
5 2918 2918 1.055 3724
6 2918 2918 1.056 3910
Copyright Oxford University Press 2020 14-29
Example 14-9 Inflation Effect on
After-tax Calculation

a) Inflation rate = 0%
Taxable 28%
SL Depr. ATCF(A$)
Year BTCF Income Tax
0 −$12,000 −$12,000
1-6 2,918 $2000 $918 −$257 2,661
IRR 12.0% 8.8%
=RATE(6,CF0,CF1-6) =RATE(6,CF0,CF1-6)

Or, for ATCF, 12,000 = 2661(P/A,i,6)

(P/A,i,6) = 12,000/2661 = 4.51
i = 8.8%

Copyright Oxford University Press 2020 14-30

Example 14-9 Inflation Effect on
After-tax Calculation

b) Inflation rate = 5%
Taxable
BTCF SL Depr.
Year Income 28% Tax ATCF(A$)
0 −$12,000 −$12,000
1 3,064 $2000 $1064 −$298 2,766
2 3,217 2000 1217 −341 2,876
3 3,378 2000 1378 −386 2,992
4 3,547 2000 1547 −433 3,114
5 3,724 2000 1724 −483 3,241
6 3,910 2000 1910 −535 3,375

Copyright Oxford University Press 2020 14-31

Example 14-9 Inflation Effect on
After-tax Calculation
b) Inflation rate = 5%
Conversion Year-0 $, PW at PW at
ATCF(A$)
Year Factor ATCF 7% 8%
0 −$12,000 −$12,000 −$12,000 −$12,000
1 2,766 𝗑 1.05-1 = 2,634 2,462 2,439
2 2,876 𝗑 1.05-2 = 2,609 2,279 2,237
3 2,992 𝗑 1.05-3 = 2,585 2,110 2,052
4 3,114 𝗑 1.05-4 = 2,562 1,954 1,883
5 3,241 𝗑 1.05-5 = 2,540 1,811 1,728
6 3,375 𝗑 1.05-6 = 2,519 1,678 1,587
+294 −74

Linear interpolation between 7 and 8%: 7% + 1%[294/(294+74)] = 7.8%

=IRR(ATCF0:ATCF6) = 7.8%
Copyright Oxford University Press 2020 14-32
Example 14-10 Using Spreadsheet
for Inflation Calculation
Labor costs $350K in Yr 1, increasing at 6%,
Transportation: unit costs inflate at 5%; volume changes so costs in
Time-0 $s = $40K, $60K, $50K, $30K for yrs 1 thru 4
Inflation = 3%; i’ = 7%; find EAC in Yr-0 dollars

Copyright Oxford University Press 2020 14-33

Example 14-11 Inflation Effect on
After-tax Calculation
For Example 14-9, Calculate IRR without inflation

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Example 14-11 Inflation Effect on
After-tax Calculation
For Example 14-9, Calculate IRR with 5% inflation

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