Inflation and its impact on Project Cash Flows

Concept of Inflation:

Inflation is a loss in the purchasing power of money over time. Inflation means the cost of an item tends to increase over time or to put in an alternative way, the same dollar amount buys less of an item over time. When net demand of goods and services exceed the total supply, because of less supply the net price of these goods or services increases and this kind of situation is called inflation. Inflation produces the effects on the health of an economy. The uncertainty about the future behavior of inflation rate may restrict the investors to invest in the market. Because of an inflation, rupees at present will not be equivalent to rupees at future. We know that the engineering economic analysis requires that evaluations be made on an equivalent basis. So it is important for us to be able to incorporate the effects of inflation.

Deflation is the opposite of inflation, in that prices usually decrease over time, hence a specified dollar amount gains in purchasing power. Inflation is far more common than deflation in the real world.

Causes of inflation:

1. Increase in cost of production
2. Increase in profit margin by industries and business houses
3. Effects of increase in price at a specific section of a mass industry
4. Hyperinflation may be due to heavy war
5. Stagflation occurs when facing economic stagnation and high unemployment rate

Measuring Inflation:

Before introducing inflation into an engineering economic problem, we need a means of isolating and quantifying its effect. Users usually have a relative sense of how their purchasing power is declining by their experience over the years. Economists have developed a measure called Consumer Price Index (CPI) which is based on a typical market of goods and services essential for the average consumer such as food and alcoholic beverages, apparel, housing, transportation, entertainment, personal care, medical care and other goods and services. CPI makes the comparison of the cost of the typical market of goods and services in a current month with its cost 1 month ago, 1 year ago or 10 years ago, called the base period. Consumers tend to adjust their shopping practices to changes in relative prices and they tend to substitute other items whose prices have increased gently in relative terms. CPI does not consider into account this sort of consumer behavior. CPI is called a price index rather than a cost of living index. It is a good measure of the general increase in prices of consumer products.

In performing engineering economic analysis, the suitable price indexes must be selected to estimate the prices increases of raw materials, finished products, and operating costs. So after survey, a measure called Producer Price Index (PPI) was introduced as a good measure of the industrial price rises.

Average Inflation Rate (f):

Average Inflation Rate (f) is a single rate computed taking into account for the effect of changing yearly inflation rates over a period of several years. Since each individual year’s inflation rate is based on the previous year’s rate, all these rates have a compounding effect.

Suppose we want to calculate ‘f’ for a two year period. The first year’s inflation percentage is 4% and the second year’s rate is 8% at a base price of Rs.100.

Step 1: To find the price at the end of the second year, the process of compounding is used:

Rs. 100(1 + 0.04)(1 + 0.08) = Rs.112.32

Step 2: To find the average inflation rate ‘f’, the following equivalence equation is established:

Rs.100(1 + f)² = Rs.112.32 OR, Rs.100(F/P, f, 2) = Rs.112.32

Solving for ‘f’ yields, f = 5.98%

We can say that the price increase in the last two years is equivalent to a 5.98% per year of the average rate. This is geometric not an arithmetic average over a several year periods. Our computations are also simplified by single average rate rather than a different rate for each year’s cash flows.

General Inflation Rate (f’):

This average inflation rate is calculated on the basis of the CPI for all items in the market. The market interest rate is expected to respond to this common inflation rate.

In terms of CPI, CPI_n = CPI₀(1 + f’)ⁿ ……(i)

Where, CPI_n = CPI at the end period ‘n’

CPI₀ = CPI for the base period

We can calculate the annual general inflation rate by knowing the CPI values for two consecutive years as

f_n’ = (CPI_n – CPI_n – 1)/ CPI_{n – 1} ……(ii)

Specific Inflation Rate:

This rate is based on CPI, specific to just one particular item such as labor, material, housing or gasoline.

Actual Vs Constant Dollars:

Actual (Current) Dollars (A_n) are the estimates of future cash flows for year ‘n’ that consider into account of any anticipated changes in amounts resulted in inflationary or deflationary effects.

Constant (Real) Dollars (A_n’) represents constant purchasing power independent of the passage of time.

A_n and A_n’ are related by the formula:

A_n = A_n’(1 + f’)ⁿ = A_n’(F/P, f’, n)……(iii)

Where, f’ is general inflation rate

Equivalence calculation under inflation:

To factor in changes in purchasing power, i.e. inflation, we may use either constant dollar or actual dollar analysis which produces the same solution however each method requires the use of different interest rate and procedure.

Two types of interest rates are used in equivalence calculations; market interest rate and inflation free interest rate.

Market Interest rate (i) takes into account the combined effects of the earning value of capital and any anticipated inflation or deflation. It is used for loans, saving account as well as in evaluating the investment project.

Inflation-free Interest rate (i’) is an estimate of the true earning power of money when the inflation effects have been removed. It is commonly the real interest rate.

1. Constant Dollar Analysis:

Here we want to calculate the equivalent present worth of the constant dollars (A_n’) occurring in the year n after all cash flow elements are already given in constant dollars. We should use i’ to account for only the earning power of money in the absence of an inflationary effect. The equivalent present worth is obtained as:

P_n = A_n’/ (1 + i’)ⁿ

This analysis method is common in the assessment of many long-term public projects as the government does not pay income taxes.

2. Actual Dollar Analysis:

Consider all cash flow elements are estimated in actual dollars. There are two methods to find the equivalent present worth of the actual dollar amount (A_n).

a. Deflation Method:

It requires two steps. First, actual dollars are changed onto equivalent constant dollars by discounting by the general inflation rate which removes the inflationary effect. Next is to use i’ to find the equivalent present worth.

b. Adjusted Discount Method:

This method merges the process performing deflation and discounting in one step. Mathematically,

P_n = [A_n/ (1 + f’)ⁿ]/ (1 + i’)ⁿ = A_n/ [(1 + f’)(1 + i’)]ⁿ………(i)

Since the market interest rate (i) reflects both the earning power and the purchasing power, we have P_n = A_n/ (1 + i)ⁿ …………(ii)

Comparing (i) and (ii), we get,

(1 + i) = (1 + f’)(1 + i’) …………(iii)

Simplifying, i = i’ + f’ + i’.f’ …………(iv)

3. Mixed Dollar Analysis:

There might be the condition of some cash flow elements expressed in constant dollars and other elements in actual dollars. In this situation, we convert all cash flow elements into same dollar units (either constant or actual) and follow either constant or actual dollar analysis as required.

Impact of Inflation on Economic Evaluation

The modest inflation rate is generally ignored in the economic evaluation of proposals. But it should be considered when inflation is high and some goods and services escalate much more rapidly than others. Once analysis recognizes that inflation has an impact on most investment opportunities and therefore deserves consideration in their appraisals, they must decide on the most appropriate method in which to include it. There are two basic methods considered.

1. Estimate inflation effects by converting all cash flows to money units that have constant purchasing power called constant dollars. This approach is most suitable for before tax analysis when all cash flow components inflate at uniform rates.
2. Estimate cash flows in a number of money units actually exchanged at the time of each transaction. These money units are called actual dollars. The actual dollar approach is easier to understand and apply and is more versatile than the constant dollar method.

Two different forms of interest rates are used in economic evaluation of a project: Market interest rate (i) and Inflation – free interest rate (i’).

A number of individual elements of project evaluation can be distorted by inflation. They are stated below.

BIBLIOGRAPHY:

Chan S.Park, Contemporary Engineering Economics, Prentice Hall, Inc.
E. Paul De Garmo, William G.Sullivan and James A. Bonta delli, Engineering
Economy, MC Milan Publishing Company.
James L. Riggs, David D. Bedworth and Sabah U. Randhawa,Engineering
Economics, Tata MCGraw Hill Education Private Limited.