Lecture 10

10
PRICE CHANGES AND

EXCHANGE RATES
Muhammad Aljalali, Ph.D.

Introduction
2
General price inflation, which is defined here as an

increase in the average price paid for goods and
services bringing about a reduction in the
purchasing power of the monetary unit, is a
business reality that can be affect the economic
comparison of alternatives.
CPI (Consumer price index).
PPI (Producer price index).
10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

Introduction
3

, % = %

, % = %

For example, if CPI for 2006 was 201.6, and CPI for 2007 is 208.0, then the
inflation rate in 2007 is:

. .
% = % = . %
.

Terminology and Basic Concepts
4
Actual dollars (A$) The number of dollars

associated with a cash flow (or a noncash-flow
amount such as depreciation) as of the time it
occur. Sometimes, A$ referred to as nominal
dollars, current dollars, then-current dollars, and
inflated dollars.
Real dollars (R$) Dollars expressed in terms of the
same purchasing power relative to a particular
time. Sometimes, R$ are termed constant dollars.

5
General price inflation (or deflation) rate (f) A

measure of the average change in the purchasing
power of a dollar during a specified period of
time.
Market (nominal) interest rate (im) The money paid
for the use of capital, normally expressed as an
annual rate (%) that includes a market adjustment
for the anticipated general price inflation rate in
the economy.

6
Real interest rate (ir) The money paid for the use of
capital, normally expressed as an annual rate (%)
that does not include a market adjustment for the
anticipated general price inflation rate in the
economy. It sometimes called the inflation-free
interest rate.
Base time period (b) The reference or base time
period used to define the constant purchasing
power of real dollars.

The Relationship between Actual
Dollars and Real Dollars
7

$ = $ = $ , %,
+
The relationship for a specific type of cash flow, j, would

be included as:

$ , = $ , = $ , , %,
+

8
Example 10.1
Suppose that your salary is $45,000 in year one, will
increase at 4% per year through year four, and is
expressed in actual dollars as follows:

9
Example 10.1
If the general price inflation rate (f) is expected to

average 6% per year, what is the real-dollar
equivalent of these actual-dollar salary amounts?
Assume that the base time period is year one (b = 1).

10
Solution 10.1
Year Salary (R$, b = 1)

1 45,000(P/F,6%,0) = 45,000
2 46,800(P/F,6%,1) = 44,151
3 48,672(P/F,6%,2) = 43,318
4 50,619(P/F,6%,3) = 42,500
11
Example 10.2
An engineering project team is analyzing the potential
expansion of an existing production facility. Different design
alternatives are being considered. The estimated after-tax
cash flow (ATCF) in actual dollars for one alternative is
shown in column 2 of the following table. If the general price
inflation rate (f) is estimated to be 5.2% per year during the
eight-year analysis period, what is the real-dollar ATCF that
is equivalent to the actual-dollar ATCF? The base time
period is year zero (b = 0).
12
Solution 10.2
(1) (2) (3) (4)
End-of-Year ATCF (P/F,f%,k-b) ATCF
k (A$) =[1/(1.052)k-0] (R$), b = 0
0 -172,400 1.0 -172,400
1 -21,000 0.9506 -19,963
2 51,600 0.9036 46,626
3 53,000 0.8589 45,522
4 58,200 0.8165 47,520
5 58,200 0.7761 45,169
6 58,200 0.7377 42,934
7 58,200 0.7013 40,816
8 58,200 0.6666 38,796
The Correct Interest Rate to Use in
Engineering Economy Studies
13

14
The Relationship among im, ir, and f
+ = + +
= + +

=
+

15
Example 10.3
Suppose that $1,000 is deposited each year for five
years into an equity (common stock) account earning 8%
per year. During this period, general inflation is
expected to remain at 3% per year. At the end of five
years, what is the dollar value of the account in terms of
todays purchasing power (i.e., real dollars)?

16
Solution 10.3
Immediately after the fifth deposit, the actual dollar
value of the equity account is
(A$)5 = $1,000(F/A,8%,5) = $5,866.60
The value of the account in todays purchasing power

is
(R$)5 = $5,866.60(P/F,3%,5) = $5,060.53

17
Example 10.4
In example 10.1, your salary was projected to increase
at the rate of 4% per year, and the general price
inflation rate was expected to be 6% per year. Your
resulting estimated salary for the four years in actual
and real dollars was as follows:

18
Example 10.4
What is the present worth (PW) of the four-year actual-

and real-dollar salary cash flows at the end of year
one (base year) if your personal MARRm is 10% per
year (im)?

19
Solution 10.4
Actual-dollar salary cash flow:
PW(10%) = $45,000 + $46,800(P/F,10%,1)

+ $48,672(P/F,10%,2)
+ $50,619(P/F,10%,3) = $165,798

20
Solution 10.4
Real-dollar salary cash flow:
. .
= = = . , . %
+ .

. % = $, + $,
.

+$, + $,
. .
. % = $,

Fixed and Responsive Annuities
21

22
Included in engineering economy studies are certain

quantities unresponsive to general price inflation. For
instance, depreciation, amounts, once determined do not
increase (with present accounting practices) to keep pace
with general price inflation; lease fees and interest
changes typically are contractually fixed for a given
period of time. Thus, it is important when doing an actual-
dollar analysis to recognize the quantities that are
unresponsive to general price inflation, and when doing a
real-dollar analysis to convert these A$ quantities to R$
quantities.
23
Example 10.5
Suppose the deflation occurs in the U.S. economy and that
the CPI (as a measure of f) is expected to decrease an
average of 2% per year for the next five years. A bond
with a face (par) value of $100,000 and a life of five
years (i.e., it will be redeemed in five years) pays an
interest (bond) rate of 5% per year. The interest is paid to
the owner of the bond once each year. If an investor
expects a real rate of return 4% per year, what is the
maximum amount that should be paid now for this bond?

24
Solution 10.5
The cash flow over the life of the bond are:
0.05($10,000) = $500 per year (actual dollar)
The face value of the bond after 5 years is $10,000 (actual
dollars)
im = ir + f + ir(f) = 0.04 0.02 0.04(0.02)
= 0.0192, or 1.92% per year.
The current market value of the bond is:
PW = $500(P/A,1.92%,5) + $10,000(P/F,1.92%,5)
= $500(4.7244) + $10,000(0.9093) = $11,455.
25
Example 10.6
The cost of a new and more efficient construction equipment is
$180,000.
It is estimated (in base year dollars, b = 0) that the equipment
will reduce current net operating cost by $48,000 per year (for
6 years) and will have a $30,000 market value at the end of the
6th year.
For simplicity, these cash flows are estimated to increase at the
general price inflation rate (f = 8% per year).
Due to new features on the equipment, it is necessary to contract
for some maintenance support during the first three years. The
maintenance contract will cost $2,800 per year.
26
Example 10.6
This equipment will be depreciated under the SL method,
The effective income tax rate (t) is 35%; the selected analysis
period is 6 years; and the MARRm (after taxes) is im = 15% per
year.
a) Based on an actual-dollar after tax analysis, is this capital
investment justified?
b) Develop the ATCF in real dollars.

27
Solution 10.6(a)
End of (1) (2) (3) (4) (5) (6) Income (7)
Year A$ Cash Contract BTCF Depr. Taxable Taxes ATCF
(k) Flows (A$) (A$) (A$) Income (t =35%) (A$)
0 -$180,000 -$180,000 -$180,000
1 51,840 -$2,800 49,040 $25,000 $24,040 -$8,400 40,640
2 55,987 -$2,800 53,187 25,000 28,187 -9,865 43,322
3 60,466 -$2,800 57,666 25,000 32,666 -11,433 46,233
4 65,303 65,303 25,000 40,303 -14,106 51,197
5 70,527 70,527 25,000 45,527 -15,934 54,593
6 76,169 76,169 25,000 51,169 -17,909 58,260
6 47,606 47,606 47,606 -16,662 30,944

28
Solution 10.6(a)
End of (7) (8) (9)
Year ATCF PW Factor PW
(k) (A$) 1/(1 + im)k-b
0 -$180,000 1 -$180,000
1 40,640 0.8696 35,339
PW = $13,473 > 0.0
2 43,322 0.7561 32,756
3 46,233 0.6575 30,398 The equipment is
4 51,197 0.5718 29,274 justified investment
5 54,593 0.4972 27,144
6 58,260 0.4323 25,185
6 30,944 0.4323 13,377

29
Solution 10.6(b)
End of (7) (8) (9)
Year ATCF R$ adjust. ATCF
(k) (A$) 1/(1 + f)k-b (R$) . .
= =
0 -$180,000 1 -$180,000 + .
1 40,640 0.9259 37,629
= . = . %
2 43,322 0.8573 37,140
3 46,233 0.7938 36,700
4 51,197 0.7350 37,630
5 54,593 0.6806 37,156
6 58,260 0.6302 36,715
6 30,944 0.6302 19,501

30
Solution 10.6(b)
End of (9) (10) (11)
Year ATCF PW Factor PW
(k) (R$) 1/(1 + ir)k-b
0 -$180,000 1 -$180,000
1 37,629 0.9391 35,337 PW = $13,480 > 0.0
2 37,140 0.8820 32,757
3 36,700 0.8283 30,399 The equipment is
4 37,630 0.7779 29,272 justified investment
5 37,156 0.7306 27,146
6 36,715 0.6861 25,190
6 19,501 0.6861 13,379

Differential Price Changes
31
1. Differential price inflation (or deflation rate)(ej): The increment

(%) of price change (in the unit price cost for a fixed amount),
above or below the general price inflation rate, during a period
(normally a year) for good or service j.
2. Total price escalation (or de-escalation) rate (ej): The total rate
(%) of price change (in the unit price or cost for a fixed amount)
during a period (normally a year), for good or service j. the
total price escalation rate for a good or service includes the
effect of both the general price inflation rate (f) and the
differential price inflation rate (ej) on price changes.

32
The Relationship among ej, ej, and f
+ = +
= + +

=
+

33
Example 10.7
The prospective maintenance expenses for a commercial heating,
ventilating, and air-conditioning (HVAC) system are estimated to
be $12,200 per year in base-year dollars (assume that b = 0).
The total price escalation rate is estimated to be 7.6% for the
next three years (e1,2,3 = 7.6%), and for years four and five is
estimated to be 9.3% (e4,5 = 9.3%). The general price inflation
rate (f) for this five-year period is estimated to be 4.7% per
year.
Develop the maintenance expense estimates for years one
through five in actual dollars and in real dollars, using ej and ej
values, respectively.

34
Solution 10.7

. .
, , = = . , . %
.

. .
, = = . , . %
.

35
Solution 10.7

Foreign Exchange Rates and
Purchasing Power Concepts
36
ilm = rate of return in terms of a market interest rate relative to

the currency of local country.
ifm = rate of return in terms of a market interest rate relative to
the currency of foreign country.
fe = annual devaluation rate (rate of annual change in exchange rate)
between the currency of a foreign country and the currency of local
country.

37
+
+ =
+
= + +

=
+

38
Example 10.8
The CMOS Electronics Company is considering a capital investment of
50,000,000 pesos in an assembly plant located in a foreign country.
Currency is expressed in pesos, and the exchange rate is now 100
pesos per U.S. dollar.
The country has followed a policy of devaluing its currency against the
dollar by 10% per year to build up its export business to the United
States. This means that each year the number of pesos exchanged for
a dollar increases by 10% (fe = 10%), so in two years (1.10)2(100) =
121 pesos would be traded for one dollar. Labor is quite inexpensive
in this country, so management of CMOS Electronics feels that the
proposed plant will produce the following rather attractive ATCF,
stated in pesos.

39
Example 10.8
End of Year 0 1 2 3 4 5
ATCF
(millions of -50 +20 +20 +20 +30 +30
pesos)
If CMOS Electronics requires a 15% IRR per year, after taxes, in

U.S. dollars (ilm = ius) on its foreign investments, should this plant
be approved? Assume that there are no unusual risks of
nationalization of foreign investments in this country.

40
Solution 10.8
To earn a 15% annual rate of return in U.S. dollars, the foreign
plant must earn:
ifm = ilm + fe + fe(ilm)
= 0.15 + 0.10 + 0.15(0.10) = 0.265, or 26.5%

41
Solution 10.8

42
Solution 10.8
=
.
$ =
.
. .
= = . , . %
.

Homework
43
Self homework:
Examples 8-2, 8-3, 8-12 in the
textbook.
Class homework:
Problems 8-2, 8-6, 7-7, 8-7, 8-14, 8-
18, 8-27, 8-37, 8-39.

Lecture 10

Caricato da

Informazioni sul documento

Descrizione originale:

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Lecture 10

Caricato da

Copyright:

Formati disponibili

10

PRICE CHANGES AND

Muhammad Aljalali, Ph.D.

General price inflation, which is defined here as an

PPI (Producer price index).

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

Actual dollars (A$) The number of dollars

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

General price inflation (or deflation) rate (f) A

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

The relationship for a specific type of cash flow, j, would

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

If the general price inflation rate (f) is expected to

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

Year Salary (R$, b = 1)

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

The Relationship among im, ir, and f

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

The value of the account in todays purchasing power

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

What is the present worth (PW) of the four-year actual-

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

Actual-dollar salary cash flow:

PW(10%) = $45,000 + $46,800(P/F,10%,1)

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

Included in engineering economy studies are certain

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

1. Differential price inflation (or deflation rate)(ej): The increment

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

The Relationship among ej, ej, and f

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

ilm = rate of return in terms of a market interest rate relative to

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

If CMOS Electronics requires a 15% IRR per year, after taxes, in

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

10. Price Changes and Exchange Rates Muhammad Aljalali Ph.D.

Potrebbero piacerti anche