EQUIVALENCE CALCULATIONS

UNDER INFLATION

CHAPTER 4
 Inflation and Economic Analysis

➢ What is inflation?

➢ How do we measure inflation?

➢ How do we include the effect of inflation in equivalence calculation?

 What is inflation?

➢ Inflation is the rate of increase in the level of prices for goods and
services, which affects the purchasing value of money.

➢ A loss in the purchasing power of money over time.

➢ The same dollar amount buys less of an item over time.

Earning Power
How much you currently make at your place of employment plays a major
part in your earning power.

Purchasing power
The value of a currency expressed in terms of the amount of goods or
services that one unit of money can buy.

Decrease in purchasing power (inflation)

Increase in Purchasing Power (deflation)

 Purchasing Power

$100 $100

2000 2000 2010

You could buy 50 Big Macs in year 2000. You can only buy 40 Big Macs in year 2010.

25%
$2.00 / unit $2.50 / unit
Price change
due to
inflation
 Deflation

$100 $100

-2 -1 0 1 -2 -1 0 1

You could purchase 63.69 gallons of You can now purchase 80 gallons of
unleaded gas a year ago. unleaded gas.

$1.57 / gallon 20.38% $1.25 / gallon

Price change due to deflation

 Inflation Terminology - I

Consumer Price Index (CPI) or cost-of-living index

➢ The Consumer Price Index (CPI) is a measure of the average change over
time in the prices paid by urban consumers for a market basket of
consumer goods and services.

Whose buying habits does the CPI reflect?

➢ The CPI reflects spending patterns for each of two population groups: all
urban consumers and urban wage earners.
➢ The all urban consumer group represents about 87 percent of the total
U.S. population. It is based on the expenditures of almost all residents of
urban or metropolitan areas, including professionals, the self-employed,
the poor, the unemployed, and retired people.
➢ This market basket normally consists of items from eight major groups –
such as food and beverages, housing, apparel, transportation,
entertainment, medical care, personal care and other goods and services.
What goods and services does the CPI cover?
➢ The CPI represents all goods and services purchased for consumption by the reference
population. BLS has classified all expenditure items into more than 200 categories,
arranged into eight major groups. Major groups and examples of categories are;
1. FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, full service
meals, snacks)
2. HOUSING (rent of residence, owners' equivalent rent, fuel oil, bedroom furniture)
3. APPAREL (men's shirts and sweaters, women's dresses, jewelry)
4. TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle
insurance)
5. MEDICAL CARE (prescription drugs and medical supplies, physicians' services,
eyeglasses and eye care, hospital services)
6. RECREATION (televisions, toys, pets and pet products, sports equipment,
admissions);
7. EDUCATION AND COMMUNICATION (college tuition, postage, telephone
services, computer software and accessories);
8. OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and
other personal services, funeral expenses).
➢ The CPI frequently is called a cost-of-living index, but it differs in important ways
from a complete cost-of-living measure.

➢ BLS has for some time used a cost-of-living framework in making practical decisions
about questions that arise in constructing the CPI.

➢ A cost-of-living index is a conceptual measurement goal, however, and not a

straightforward alternative to the CPI. A cost-of-living index would measure
changes over time in the amount that consumers need to spend to reach a certain
utility level or standard of living.

➢ Both the CPI and a cost-of-living index would reflect changes in the prices of goods
and services, such as food and clothing, that are directly purchased in the
marketplace.
How is the CPI market basket determined?

➢ The CPI market basket is developed from detailed expenditure information

provided by families and individuals on what they actually bought.

➢ For the current CPI, this information was collected from the Consumer
Expenditure Surveys for 2007 and 2008.

➢ In each of those years, about 7,000 families from around the country provided
information each quarter on their spending habits in the interview survey.
How are CPI prices collected and reviewed?
➢ Each month, BLS data collectors called economic assistants visit or call
thousands of retail stores, service establishments, rental units, and doctors'
offices, all over the United States, to obtain information on the prices of the
thousands of items used to track and measure price changes in the CPI.

Is the CPI the best measure of inflation?

➢ Inflation has been defined as a process of continuously rising prices or
equivalently, of a continuously falling value of money.
➢ Various indexes have been developed to measure different aspects of inflation.
The CPI measures inflation as experienced by consumers in their day-to-day
living expenses;
 CONSUMER PRICE INDEX

For example, let us say that, in 1967, the

prescribed market basket could have been
purchased for $100. Suppose the same
combination of goods and services costs $600.90
in 2006. We can then compute the CPI for 2006
by multiplying the ratio of the current price to the
base-period price by 100.

In our example, the price index is

($600.90/$100)100 = 600.90, which means that
the 2006 price of the contents of the market
basket is 600.90% of its base-period price.

Figure 4-1 Measuring inflation based on CPI

 Inflation Terminology - I

What is the Producer Price Index (PPI)?

➢ The Producer Price Index is a family of indexes that measures the average
change over time in the selling prices received by domestic producers of goods
and services.
➢ PPIs measure price change from the perspective of the seller. This contrasts
with other measures, such as the Consumer Price Index (CPI), that measure
price change from the purchaser's perspective.
➢ The consumer price index is a good measure of the general price increase of
consumer products. However, it is not a good measure of industrial price
increases.
➢ When performing engineering economic analysis, the appropriate price
indices must be selected accurately to estimate the price increases of raw
materials, finished products, and operating costs.
➢ The BLS, provides the industrial-product price index for various industrial
goods compiled monthly to evaluate wholesale price levels in the economy.
 How Does the Producer Price Index Differ from the Consumer Price Index?

➢ The Producer Price Index for Finished Goods tracks the average change in prices
over time of domestically produced and consumed commodities. The index is
comprised of prices for both consumer goods and capital equipment, but excludes
prices for services.

➢ The All Items CPI measures the average change in prices over time of goods and
services purchased for personal consumption by urban U.S. families.

➢ The conceptual and definitional distinctions of the PPI and CPI are consistent with
the uses of these two major economic indicators.

➢ The PPI is used to deflate revenue to measure real growth in output and the CPI is
used to adjust income and expenditures for changes in the cost of living.
 Inflation Terminology - I

➢ Average Inflation Rate ( f ) a single rate that accounts for the effect of unstable
yearly inflation rates over a period of several years. (inflation is different every
year)

➢ General Inflation Rate ( f ) the average inflation rate calculated based on the CPI
for all items in the market basket.
 Average Inflation Rate ( f )
Fact: Base Price = $100 (year 0)
Inflation rate (year 1) = 4%
Inflation rate (year 2) = 8%
Average inflation rate over 2 years?

Step 1: Find the actual inflated price at the end of year 2.

$100 (1 + 0.04) (1 + 0.08) = $112.32

Step 2: Find the average inflation rate by solving the $112.32

following equivalence equation.

2
$100 ( 1+ f ) = $112.32 0 1
f = 5.98% 2

$100
 Consumer Price Indexes for 1963 and 2004

91.7 100 561.23

2004
1963 1967

Average inflation rate = 4.52%

561.23  91.70(1  f ) 41
f  41
6.1203  1
 4.5176%
 Example 4.1 Calculating Average Inflation Rate

F = P (1+ f )N $22,218 = $15,518 (1+ f )6 = –1

f = 1.0616 – 1 = 0.0616 f = 6.16%
Item 2006 Price 2000 Price Average Inflation
(CPI) Base Period: 1982 - 84 = 100 F P Rate (%)

Consumer price index (CPI) $200.43 $171.20 2.66

Postage 0.39 0.33 2.82
Homeowners Insurance 617.00 500.00 3.57
Private college tuition and fees 22,218 15,518 6.16
Gasoline 2.56 1.56 8.61
Haircut 15.00 10.50 6.12
Car (Toyota Camry) 22,900 21,000 1.45
Natural gas (MBTU) 7.08 3.17 14.33
Baseball tickets 171.19 132.44 4.37
Health care (per year) 2,351.00 1,656.00 6.01
 Yearly and Average Inflation Rates

Year Cost
The accompanying table shows a utility company's cost to supply a
0 $504,000 fixed amount of power to a new housing development; the indices are
1 538,000 specific to the utilities industry. Assume that year 0 is the base period.
2 577,000
Determine the inflation rate for each period, and calculate the
3 629,500
average inflation rate over the three years.

Inflation rate during year 1 (f1):

($538,000 - $504,000) / $504,000 = 6.83%
Inflation rate during year 2 (f2):
($577,000 - $538,000) / $538,000 = 7.17 %
Inflation rate during year 3 (f3):
($629,500 - $577,000) / $577,000 = 9.10%
The average inflation rate over 3 years is
$629,500 1/ 3
F = P (1+ f )N f  ( )  1  0.0769  7.69%
$504,000
 General Inflation Rate ( f )

This average inflation rate is calculated on the basis of CPI for all items in the market
basket.The market interest rate is expected to respond to this general inflation rate.
In terms of CPI, we define the general inflation rate as

20
 ACTUAL VERSUS CONSTANT DOLLARS

 Due to inflation, the purchasing power of the dollar changes over time.

 To compare dollar values of different purchasing power from one period to

another, they need to be converted to dollar values of common purchasing power
– conversion from actual to constant dollars or from constant to actual dollars.

 To introduce the effect of inflation into our economic analysis, we need to define
two inflation – related terms.
 Inflation Terminology – II
The effect of inflation into economic analysis

Actual (current) Dollars (An ):

Estimates of future cash flows for year n that take into account any anticipated
(expected) changes in amount caused by inflationary or deflationary effects.

Actual dollars are the number of dollars that will be paid or received,
regardless of how much these dollars are worth. Usually, these amounts are
determined by applying an inflation rate to base-year dollar estimates.

Constant (real) Dollars (A'n):

Represents constant purchasing power independent of the passage of time. We

will assume that the base year is always time zero unless it is specified
otherwise.

22
Conversion from Constant to Actual Dollars
 Conversion from Actual to Constant Dollars
_ _
n
A' n  An (1  f )  An ( P / F, f , n )

$1,000 n  3 $1,260
_
f  8%

3
3
Actual
Constant -3 Dollars
Dollars $1,260 (1 + 0.08)
= $1,000
Example

The table shown lists the winners, and their prize monies in actual dollars, from
the U. S. Open Golf Championship from 2002 to 2006. Convert the prize
monies into equivalent 2006 dollars. In doing so,

a) Determine the growth (average) rate of the prize money in actual dollars over
the four-year period.

b) Find the equivalent prize money for each winner, stated in terms of year
2006 dollars.

c) Determine the growth rate of the prize money in constant (real) dollars.

d) If the current trend continues, what would be the expected prize money
be in actual dollars for the winner in 2007?
 Example  CPI n 
1/ n

f   1
 CPI 0 

The prize money Consumer Equivalent Prize

(in actual dollars) price index Inflation money in 2006
Year Winner
dollars
rate
2002 Tiger Woods $1,000,000 179.8

2003 Jim Furyk $1,080,000 183.8

2004 Retief Goosen $1,125,000 188.0

2005 Micheal Campbell $1,170,000 194.6

2006 Geoff Ogilvy $1,225,000 200.43

 Example
1/ n
 CPI n 
f   1
Given Given  CPI 0 

The prize money Consumer Inflation Equivalent Prize

(in actual dollars) price index money in 2006
Year Winner rate
dollars

2002 Tiger Woods $1,000,000 179.8 $1,114,779

2003 Jim Furyk $1,080,000 183.8 2.22% $1,177,813

2004 Retief Goosen $1,125,000 188.0 2.29% $1,199,422

2005 Micheal Campbell $1,170,000 194.6 3.51% $1,205,100

2006 Geoff Ogilvy $1,225,000 200.43 3.00% $1,225,000

F2006  1000(1  0.0222)(1  0.0229)(1  0.0351)(1  0.03)  1114.7785

 Equivalence Calculation Under Inflation

1. Types of Interest Rate

Market Interest rate ( i )

Inflation-free interest rate ( i' )
2. Types of Cash Flow
In Constant Dollars
In Actual Dollars
3. Types of Analysis Method

Constant Dollar Analysis

Actual Dollar Analysis

Deflation Method
Adjusted-discount method
 Inflation Terminology - III

 Inflation-free Interest Rate ( i' ): an estimate of the true earning power of

money when the inflation effects have been removed.

➢ This rate is known as real interest rate, and it can be computed if the
market interest rate and the inflation rate are known.

 Market interest rate ( i ) known as the nominal interest rate, which takes
into account the combined effects of the earning value of capital (earning
power) and any anticipated inflation or deflation (purchasing power).

➢ Most firms use a market interest rate (also known as inflation-adjusted

required rate of return) in evaluating their investment projects.

30
 Inflation and Cash Flow Analysis

Constant Dollar analysis (A' n) ……… (inflation free interest rate i' )

➢ All cash flow elements are given in constant dollars

➢ Compute the equivalent present worth of constant dollars (A' n) in year n.

➢ In the absence of inflationary effect, we use i' to account the earning power
of the money.

31
 Inflation and Cash Flow Analysis

Actual Dollar Analysis (An ) ………….. ( market interest rate i )

➢ All the cash flow elements are estimated in actual dollars.

➢ To find the equivalent present worth of this actual dollar amount in year n.

➢ We use two steps to convert actual dollars into equivalent present worth dollars.

32
 Actual Dollars (An ) Analysis

Method 1: Deflation Method

a) Convert actual dollars into equivalent constant dollars by discounting

with the general inflation rate, a step that removes the inflationary effect.
Then:
b) Now we can use i' (inflation free interest) to find the equivalent
present worth.

Method 2: Adjusted-discount Method

Combine two steps into one step, which performs deflation and
discounting in one step.
 Net Cash Flows in
n Actual Dollars
0 -$75,000
Example: 1 32,000
Equivalence Calculation when 2 35,700
cash flows are in actual dollars:
3 32,800
4 29,000
Deflation Method 5 58,000

Applied instrumentation, a small manufacturer of custom electronics to make investment to

produce sensors and control systems that have been requested by a fruit drying company. The
work would be done under a contract that would terminate in five years. The project is
expected to generate the above cash flows in actual dollars:
a) What are the equivalent constant dollars if the general inflation rate is 5% per year.
b) Compute the present worth these cash flows in constant dollars at i' = 10%
 Step 1: Convert Actual dollars to Constant dollars

Cash Flows in Multiplied by Cash Flows in

n Actual Dollars Deflation Constant Dollars
Factor ( f ) = 5%

0 -$75,000 1 -$75,000

1 32,000 (1+0.05)-1 30,476

2 35,700 (1+0.05)-2 32,381

3 32,800 (1+0.05)-3 28,334

4 29,000 (1+0.05)-4 23,858

5 58,000 (1+0.05)-5 45,445

Step 2: Convert Constant dollars to Equivalent Present Worth

Multiplied by
n Cash Flows in Discounting Equivalent Present
Constant Dollars Factor Worth
i' = 10%
0 -$75,000 1 -$75,000
1 30,476 (1+0.10)-1 27,706
2 32,381 (1+0.10)-2 26,761
3 28,334 (1+0.10)-3 21,288
4 23,858 (1+0.10)-4 16,295
5 45,445 (1+0.10)-5 28,218
$45,268
 Deflation Method
Converting actual dollars to constant dollars
and then to equivalent present worth
n=0 n=1 n=2 n=3 n=4 n=5

Actual
Dollars
-$75,000 $32,000 $35,700 $32,800 $29,000 $58,000

Constant
-$75,000 $30,476
Dollars $32,381 $28,334 $23,858 $45,455

Present
Worth -$75,000
$27,706 $26,761 $21,288 $16,295 $28,218

$45,268
 Adjusted-Discount Method
Perform Deflation and Discounting in One Step

An
Pn 
(1  i ) n
An An

(1  i ) n  (1  f ) n (1  i ') 
n
An Step 1  
(1  f ) n (1  i )  (1  f )(1  i ')
Pn 
(1  i ' ) n  1  i ' f  i ' f

An  
Step 2  i  i  f  i f
(1  f ) n (1  i ' ) n
_ _
i  f  i(1  f )

i  f
i  
1 f
Previous Example i  i'  f  i' f
Adjusted - Discounted  0.10  0.05  ( 0.10 )( 0.05)
Method  15.5%

n Cash Flows in Multiplied Equivalent

Actual Dollars By (15.5%) Present Worth

0 -$75,000 1 -$75,000
1 32,000 (1+0.155)-1 27,706
2 35,700 (1+0.155)-2 26,761
3 32,800 (1+0.155)-3 21,288
4 29,000 (1+0.155)-4 16,296
5 58,000 (1+0.155)-5 28,217
$45,268
 Graphical Overview on Adjusted Discount Method:
Converting actual dollars to present worth dollars
by applying the market interest rate

n=0 n=1 n=2 n=3 n=4 n=5

Actual
Dollars -$75,000 $32,000 $35,700 $32,800 $29,000 $58,000

i  i  f  if  15.5%

Present $28,217
Worth -$75,000
$16,296
$26,761 $21,288
$27,706
$45,268
 MIXED DOLLAR ANALYSIS

 Consider situation that some cash flow elements are expressed in constant
(or today’s) dollars.

 In this situation, we convert all cash flow elements into same dollar units
(either constant or actual).

 If the cash flow elements are all converted into actual dollars, we can use
the market interest rate i in calculating the equivalence value.

 If the cash flow elements are all converted into constant dollars, we can
use the inflation-free interest rate i'
Example 4.7 illustrates this situation.
Example 4.7

A couple wishes to establish a college fund at a bank for their five-year-old child. The
college fund will earn 8% interest compounded quarterly. Assuming that the child
enters college at age 18, the couple estimates that an amount of $30,000 per year in
terms of today's dollars, will be required to support the child's college expenses for four
years. College expenses are estimated to increase at an annual rate of 6%.

Determine the equal quarterly deposits the couple must make until they send their child
to college. Assume that the first deposit will be made at the end of the first quarter and
that deposits will continue until the child reaches age 17. The child will enter college at
age 18 and the annual college expense will be paid at the beginning of each college year.
In other words. the first withdrawal will be made when the child is 18.
Example 4.7 Equivalence Calculation with Composite Cash Flow Elements

Convert any cash flow elements in constant dollars into actual dollars.
Then use the market interest rate to find the equivalent present value.

Age College expenses College expenses

in today’s dollars in actual dollars
18 (Freshman) $30,000 $30,000(F/P,6%,13) = $63,988

19 (Sophomore) 30,000 $30,000(F/P,6%,14) = $67,827

20 (Junior) 30,000 $30,000(F/P,6%,15) = $71,897

21 (senior) 30,000 $30,000(F/P,6%,16) = $76,211

Required Quarterly Contributions to College funds
CHAPTER 4 HOMEWORK PRACTICE PROBLEMS

12; 13; 14; 15; 22

4.12)

A company is considering buying workstation computers to support its engineering staff.

In today’s dollars, it is estimated that the maintenance costs for the computers (paid at the
end of each year) will be $20,000, $26,000, $34,000, $38,000, and $42,000 for years one
through five, respectively. The general inflation rate f is estimated to be 10% per year,
and the company will receive 16% per year on its invested funds during the inflationary period.
The company wants to pay for maintenance expenses in equivalent payment (in actual dollars)
at the end of each of the five years. Find the amount of the company’s annual payment.

SOLUTION

i = 16%, f = 10%

P = 20,000 (1.0545)-1 + 26,000 (1.0545)-2 + 34,000 (1.0545)-3 + 38,000 (1.0545)-4 + 42,000 (1.0545)-5

P =$134,289 Therefore A = $134,289 (A/P, 16%, 5) A = $41,012

4.13)
Given the cash flows in actual dollars provided in the following table, covert the cash
flows to equivalent cash flows in constant dollars if the base year is time 0. Assume
that the market interest rate is 16% and that the general inflation rate f is estimated at
4% per year.
n Actual dollars
SOLUTION 0 $20,500
4 $41,500
5 $36,500
7 $55,500

n Actual dollars Constant Dollars

0 $20,500 $20,500(P/F,4%,0) = $20,500.00
4 $41,500 $41,500(P/F,4%,4) = $35,474.37
5 $36,500 $36,500(P/F,4%,5) =$30,000.34
7 $55,500 $55,500(P/F,4%,7) = $42,175.44
4.14)
The purchase of a car requires a $15,000 loan to be repaid in monthly installments for
four years at 10% interest compounded monthly. If the general inflation rate f is 6%
compounded monthly, find the actual and constant dollar value of the 15th payment of
this loan.
 i (1  i ) N 
( A / P, i, N )  A  P  
SOLUTION  (1  i )  1
N

i = 0.1/12 = 0.00833 per month f = 0.06 /12 = 0.005per month

Using above formula we obtain A = $386.68 actual

Then using inflation rate we find
A' = 386.68 (P/F, 0.5%, 15)
A' = 386.68 x 0.9279
A' = $358.80 constant
 4.15)
A series of four annual constant dollar payments beginning with $50,000 at the end of
first year is growing at the rate of 8% per year. Assume that the base year is the current
year (n = 0). If the market interest rate is i = 16% per year and the general inflation rate
is f =10% per year, find the present worth of this series of payments, based on
EOY Constant Value Actual Value
• Constant dollar analysis
1 50,000 50,000 x 1.1 = 55,000
• Actual dollar analysis
2 50,000 × 1.08 = 54,000 54,000 × 1.12 = 65,340
i  f 0.16  0.1
i    5.45% 3 50,000 × 1.082 = 58,320 58,320 × 1.13 = 77,624
1 f 1  0.1
4 50,000 × 1.083 = 62,985.6 62,985.6 × 1.14 = 92.217
1  (1  g ) N (1  i )  N 
PW on constant analysis by using ( P / A1 , g , i, N )  P  A1  
 ig 

1  (1.08) 4 (1.0545) 4 
P  50 K  0.0545  0.08)


P  $196,672
 

P = 50K (1.0545)-1 + 54K (1.0545)-2 + 58,320 (1.0545)-3 + 62,985 (1.0545)-4

P = 47,415 + 48,562 + 49,736 + 50,939 = $196,654
4.15)
A series of four annual constant dollar payments beginning with $50,000 at the end of
first year is growing at the rate of 8% per year. Assume that the base year is the current
year (n = 0). If the market interest rate is
i = 16% per year and the general inflation rate is =10% per year, find the present
f of this series of payments, based on
worth
EOY Constant Value Actual Value
• Constant dollar analysis
• Actual dollar analysis
1 50,000 50,000 x 1.1 = 55,000
i  f 0.16  0.1
i    5.45% 2 50,000 × 1.08 = 54,000 54,000 × 1.12 = 65,340
1 f 1  0.1
3 50,000 × 1.082 = 58,320 58,320 × 1.13 = 77,624
4 50,000 × 1.083 = 62,985.6 62,985.6 × 1.14 = 92,217

1  (1  g ) N (1  i )  N 
PW on actual analysis by using ( P / A1 , g , i, N )  P  A1  
 ig 

P = 55K (1.16)-1 + 65,340 (1.16)-2 + 77,624 (1.16)-3 + 92,217 (1.16)-4

P = 47,414 + 48,558 + 49,730 + 50,931 = $196,633
4.22)

The annual fuel costs to operate a small solid-waste treatment plant are projected to be $1.8
billion, without considering for any future inflation. The best estimates indicate that the annual
inflation free interest rate ( i' ) will be 7% and the general inflation rate f = 4%. If the plant
has a remaining useful life of five years, what is the present equivalent value of its fuel cost,
using actual-dollar analysis?

SOLUTION

A B = A x (1.04)N C = B x (1.1128) -N

Period Net cash flow in Net cash flow in Equivalent present

constant $ actual $ worth
1 $1.8M $1,872,000 $1,682,243
2 $1.8M $1,946,880 $1,572,190
3 $1.8M $2,024,755.20 $1,469,336
4 $1.8M $2,105,745.40 $1,373,211
5 $1.8M $2,189,975.22 $1,283,375
Total $7,380,355