Engineering Economics

ECOR 3800 - Lecture Notes

Lecture 7: Inflation

By: Ahmed Hassan

Based on: Engineering Economics: Financial Decision Making for
Engineers, 7th edition
Introduction

2
Introduction

3
 Introduction
• Inflation: Increase in average price paid for goods and
services over time.
– Results in a reduction in purchasing power.
• Deflation: Decrease in average price paid for goods and
services over time.
– Results in an increase in purchasing power.
• Prices are likely to change over the life of an engineering
project due to inflation or deflation.
• The inflation rate is rate of increase in average prices of
goods and services over specified period.

4
9.1 Measuring the Inflation Rate
• Prices do not all move in perfect synchronization – so,
variety of methods developed to measure inflation rate
• Price indices are available to measure inflation, most
common is the Consumer Price Index (CPI).
• CPI - measures price changes in food, shelter, medical
care, transportation, apparel, and other goods/services.
• To compute CPI, Stats Canada periodically measures cost
to purchase standard basket of goods and services.
• Current cost of bundle of goods/services is compared to
the cost of the same bundle in a base year.

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9.1 Measuring the Inflation Rate
• Index for any year is dollars needed that year to buy a
fixed “basket of goods” costing $100 (in 2002 as
below).

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9.1 Measuring the Inflation Rate
• Fig 9.2 shows national inflation rate derived from CPI.
• In periods of high inflation, it is vital to include inflation
in economic analysis to avoid rejecting good projects.
• Assumption for Chapter 9: Estimates for inflation are
available over the life of the project.

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9.1 Measuring the Inflation Rate

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9.2 Economic Evaluation with Inflation
• Often use current (actual) vs. Real (constant) dollars to
fairly compare costs/prices at different times
• Current dollars is the “actual” money you pay/receive at a
certain point in time
• Real dollars is the real value of money paid at a point in
time relative to a base year. We do this by accounting for
inflation.
• Current Dollars in the base year = Real dollars in the base
year

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10
11
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9.2.1 Converting Between Real and Current
Dollars
• Having an estimate of inflation rate/period over N periods,
we can convert current dollars in period N to real dollars.
– CN = current dollars in year N
– R0,N = real dollars equivalent to CN relative to year 0
(base year)
– f = the inflation rate per year, assumed constant year 0
to N
𝐶
𝑅 , =
(1 + 𝑓)

• When omitting the base year from the notation

𝐶
𝑅 = = 𝐶 𝑃⁄𝐹 , 𝑓, 𝑁
(1 + 𝑓)
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Practice Problem
• A food plan in two years from now is expected to be $2050.
Inflation is expected to be 1.5% for the next 2 years.
• What is the real dollar value of the food plan?

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9.3 The Effect of Correctly Anticipated
Inflation
• Engineers must be aware of potential price changes
over the life of a project to adjust MARR appropriately.
• When future inflation is expected, MARR needs to be
increased.

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9.3.1 The Effect of Inflation on the MARR
• If inflation is expected, current dollars returned does not tell
us the purchasing power of the future cash flow.
• Purchasing power depends on real dollar value of earnings.
• If the inflation rate over the next year is f, the real value of
our cash flow is: P(1 + i)/(1 + f), where P is what we invest,
i is the interest rate expected, and f is the inflation rate.
• This can be used to define the real interest rate.
𝑃(1 + 𝑖′) = 𝑃(1 + 𝑖)/(1 + 𝑓)
⇒ 𝑖′ = (1 + 𝑖)/(1 + 𝑓) − 1

• Important note: The stated rate is almost always a current

rate, not a real rate (i.e. not adjusted for inflation)
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 re interest
i in t.ro
1
re arrange to solve for i
you can

OPTION 1 use current rate

Falculate f current f real
p 5000currentandor real maples current real rear rate
is a event
3
advertised rate currentrate
must be consistent

fiiiii.i.mn
F 5150 current f real
f 5089 real

MARReur MARR
icurr irea then compare to MARR real MARRreal if f

ireal 1
7 64 6.5

2.889 S MARR i do notinvest

III final atf iti

at
is 1 Itf 1 L
in f is Itf l i
 CPI consumerpriceindex

a far par E.in fj d icon irear

ireal 5.82
Leur 0.10ns

b CPI 8 18 R fJN
PICO R8
if given the option of changing cashflow
to match rate or changing rate
140
FIT
to match cashflow
e Fred
ALWAYS CHANGE RATE
fffy.ws havereceived
9.3.1 The Effect of Inflation on the MARR
• The real interest rate, i′, is interest rate that yields the
same number of real dollars in the absence of inflation as
the current interest rate yields in the presence of inflation.

• An investor who wishes to get a real rate of i′ and who

expects inflation at a rate f will require a current interest
rate of:
1+𝑖
𝑖 = −1
1+𝑓
∴𝑖 =𝑖 +𝑓+𝑖 𝑓

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9.3.1 The Effect of Inflation on the MARR
• Similarly:
MARRcur = MARRR + f + MARRR × f
• Where MARRcur is the current MARR.
• Where MARRR is the real MARR.
• Generally, as long as inflation >0; the current rate will be
higher than the real rate.

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Example 9.4

• Security trust is paying 3% on one-year guaranteed income certificates

(GICs). The inflation rate is expected to be 1.2% over the next year.
What is the real rate of interest? For a $5,000 GIC, what will be the
real dollar value of the amount received at the end of the year?

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9.3.2 The Effect of Inflation on the IRR
• The effect of expected inflation on the current IRR of a
project similar to the effect of inflation on current MARR.

𝐼𝑅𝑅 = (1 + 𝐼𝑅𝑅 )/(1 + 𝑓) − 1

𝑜𝑟
𝐼𝑅𝑅 = 𝐼𝑅𝑅 + 𝑓 + 𝐼𝑅𝑅 𝑓

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9.3.2 The Effect of Inflation on the IRR
• We see that the current MARR and the current IRR are
related in the same way to the real MARR and real IRR,
respectively.
• Therefore, correctly anticipated inflation has no effect on
project evaluations.
• Also, if the base year for real $ is “year 0” for PW, then
the numerical value of PW is the same by either:
1. PW of current $ at current MARR, or
2. PW of real $ at real MARR

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Example 9.5

• Susan got a $1,000 present from her aunt on her Birthday. She noticed
that Security trust offers 6.5% on one-year GICs. A business
newspaper predicts an inflation rate of 3.5% for the coming year.
Susan’s real MARR for such investments is 4%. If the inflation
prediction is correct, should she invest in the GIC?

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Current PW vs Real PW
• Sandy has been invested in a $6,000 GIC for the last 8
years. She went to collect her money yesterday, and she
received $13,000. To assist her in calculating her real
return on investment, she found a CPI that stated that a
consumer basket was worth $140, 8 years ago but is
worth $193 today.
a) What was the advertised rate of return for the GIC?
b) What is the average inflation rate for the 8 years?
c) What is the real value of the money she received
yesterday relative to when she invested it?
d) What is the real return on her investment?
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Current PW vs Real PW
An energy company is investing a new transformer that should
provide energy to 100,000 households. To fund this project, they
offer investors shares of the project that they can purchase for
$30,000. In return, the company will pay out equal installment of
$4,000 at the end of every year, for the next 30 years. Based on
historical data, you find out that inflation rates sit around 3.5% per
year. You find this investment intriguing, however, you do not
currently have $30,000, so make these funds available, you will
have to rely on a bank loan with an interest rate of 6%

a) What is the PW of the project using current cashflow

b) What is the PW of the project using real cashflow

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9.4 Project Evaluation Methods with
Inflation
• Engineers are typically given current MARR.
• This current (or observed) MARR consists of two parts:
– the real MARR
– an adjustment for anticipated inflation
• Projected cash flows are often stated in real dollars (and
do not include adjustments for inflation).
• The challenge is to recognize that we usually have a
current MARR but real cash flows.
• However, sometimes the cash flows have factored inflation
in. (In which case they are current cash flows.)

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9.4 Project Evaluation Methods with
Inflation
• Method 1: Work with real cash flows and find the real
MARR using an estimate of f.
• Method 2: Adjust the real cash flows to current cash flows
using f ) and apply the current MARR.
• Short term forecasts of f (<1 year) can be found in
publications such as The Globe and Mail.
• Longer term projects need longer term forecasts of
inflation if some current cash flows fixed by contract.
• It’s wise to evaluate the project(s) over a range of possible
inflation rates (i.e., Sensitivity Analysis).

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Table 9.2 Methods of Incorporating
Inflation into Project Evaluation
1. Real MARR and Real Cash Flows
The real MARR does not include the effect of expected inflation.
Cash flows are determined by today’s prices.
Correct
2. Current MARR and Current Cash Flows
The current MARR includes the effect of anticipated inflation.
Cash flows include increases due to inflation.
Correct
3. Current MARR and Real Cash Flows
The current MARR includes the effect of anticipated inflation.
Cash flows are determined by today’s prices.
Incorrect: Biased against investments
4. Real MARR and Current Cash Flows
The real MARR does not include the effect of expected inflation.
Cash flows include increases due to inflation.
Incorrect: Biased in favour of investments

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Practice Problem (1 of 4)
• Ken insulated one of his company's buildings. The
energy savings are estimated at $15,000 annually,
based on today’s energy prices. His first energy
payment starts one year from now.
• Inflation is expected to average 4% per year and
Ken’s current MARR is 8%. What is the present worth
of the energy savings over the next 10 years?

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A 15.000 based on today's prices real
MARR real

Pw
Effect of inflation on decision making
example 1
A 15-year $50,000 bond that has a dividend rate of 10% per
year, payable semiannually, is currently for sale. If the
expected real MARR of the purchaser is 8% per year,
compounded semiannually, and if the inflation rate is
expected to be 5% per year, what is the bond worth at
maturity (a) in current dollars, and (b) in real dollars?

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Effect of inflation on decision making
example 2
A self-employed chemical engineer is on contract with Dow
Chemical, currently working in a relatively high-inflation
country. She wishes to calculate a project’s PW with
estimated costs of $35,000 now and $7,000 per year
(current dollars) for 5 years beginning 1 year from now with
increases of 12% per year thereafter for the next 8 years (i.e.
a 12% increase starting in year 6 and ending in year 13).
Use a real MARR of 15% per year to make the calculations
(a) without an adjustment for inflation and (b) considering
inflation at a rate of 11% per year.

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 FED
IEIi
a MARRcorr it
us

PW 35.000 TOOO 590,1 4 7000 9 12 12 12 11 9 I n 4

83,232

b MARRcar 15 11 15 119
27.65

PW same equation different

62,436 in this case inflation is favourable