Inflation

Supplemental Reading, selected topics in

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.

ENG 3000
© Nish Balakrishnan, 2020
Learning Objectives
• Be able to correctly identify problems where inflation is a factor that
must be incorporated into analysis.
• Be able to distinguish between costs that are in constant/actual
dollars, and interest rates that are are i* or i.

• Apply techniques of inflation analysis to simple cash flow problems to

solve for values in both actual and constant dollars.

• Be able to understand the effect of buying power on goods/materials

and incorporate this effect into analysis
• Be able to translate current skills in defining/solving economic
problems into a real world setting
The Time Value of Money - Again
• In previous sections, the effect of time value of money was
considered from a basic perspective:
• Discounting and Interest based problems (Module 3)
• Another effect does take place:
• What is the relative value of $100 today vs $100 twenty years ago?
• What could you buy with $100 in cash today vs $100 a century ago?
• What is causing this difference? – Inflation, primarily
• Interesting effect:
• What happens if a cash flow says a cost is $100 per year (an annuity of $100)
• Example: cell phone plan, cost changes
• Example: contractual agreement, cost stays the same
Inflation: why it happens?
• Monetary Supply:
• The more money there is in an economy freely circulating, in comparison to the
number of goods, the lower the relatively value might be
• Circulated money example: why can’t you just print money?
• Exchange Rates and Trade
• Monetary supply is worth less or more in comparison to other goods,
commodities, and other currencies
• Example: cost of oil and the cost of general goods
• Cost – push
• Increasing costs are passed onto consumers by producers of goods/services
• Demand – pull
• More demand (over what is the given ability to supply) causes an increase in
prices
 Inflation: why it happens?
• Consumer Price Index (example)

Image Ref: https://www150.statcan.gc.ca/n1/daily-quotidien/140523/dq140523a-eng.htm

Inflation: Rate
• Define general inflation by the inflation rate: f
• Rate dictates the general effect of inflation on your analysis:
• Going by the CPI chart, has been around 2% over the last number of years
• Important to understand: not guaranteed to be 2% in any given year, but 2%
represents the average.
• Time value of money – again:
• Two effects to consider: Interest/Discounting and Inflation
• As your money earns value (due to the first effect), your money loses purchasing
power (due to the second effect)
Inflation and interest
• Understanding the interest rate - i
• Normally bank and other rates similar rates are not inflation corrected, we’ll refer
to them as i. Examples of this include credit card interest rates, loan interest
rates, bonds, stocks, savings, etc…
• Example: bank savings rate (i)
• You are looking to purchase an item worth $100 today. Instead of purchasing it
today, you decide to put the money in a savings around at the bank at 2%
effective yearly interest for 1 year. What happens in a year?
Inflation and interest
• Understanding the inflation rate effect - f
• If we know what f is over a period of time, we can factor that into the analysis by
looking at the decrease in value due to inflation.
• Example: bank savings rate (i), with inflation (f)
• You are looking to purchase an item worth $100 today. Instead of purchasing it
today, you decide to put the money in a savings around at the bank at 2%
effective yearly interest for 1 year. What happens in a year?
Inflation and interest
• Understanding the interest rate – i*
• If we know what f is over a period of time, and we know what our interest rate (i)
is, we can create a special rate that takes inflation into account – i*.
• This rate tells use if (including the effect of inflation, or corrected for it) we need to
discount cash flows.
• Example: bank savings rate (i), with inflation (f), and i*
• You are looking to purchase an item worth $100 today. Instead of purchasing it
today, you decide to put the money in a savings around at the bank at 2%
effective yearly interest for 1 year. What happens in a year? What about 20
years?
Inflation and interest
• The relationship between i, i* and f is given by:

1 + i = (1+i*)(1+f) or i =i* + f + (i*)(f)

• f is specific to the problem and also specific to:

• The year or range of years the problem takes place in
• The country that problem occurs in
• Generally, in most stable economies f ~ 2% yearly.
• i is specific to the problem and also specific to the interest/discount
rate given in a specific problem or situation. This is often called the
market rate, actual interest rate, or market interest rate.
• i* can be derived from these two values, or likewise if i* and i are
given f can be derived. This is often called the real interest rate.
• In any inflation analysis, at least two of these values must be given
Constant vs Actual Dollars
• Purchasing power changes over time due to inflation:
• $100 today vs $100 20 years ago:

• Dollar value in a specific year, at a specific point in time is referred to

as “Actual Dollars”
• Dollar value equivalent is referred to as “Constant Dollars”
• Example: Cost effective vehicle - $10,000 in 1990, f=2%
Constant vs Actual Dollars
Example Problem:
Back in 1985 a US corporation is given $75 million dollars as a loan from a bank. In
2017, the same corporation writes a cheque back to the bank for the sum of $75
million in today's money and says the loan is payed off. What is actually going on in
this situation? What if the interest rate on the loan was 5% effective, yearly. Inflation
over this period of time is an average of 2.618%.
• First step: identify i, i*, f.

• Second step: identify actual vs real dollar figures

Constant vs Actual Dollars
Example Problem – Done in Constant Dollars
Back in 1985 a US corporation is given $75 million dollars as a loan from a bank. In
2017, the same corporation writes a cheque back to the bank for the sum of $75
million in today's money and says the loan is payed off. What is actually going on in
this situation? What if the interest rate on the loan was 5% effective, yearly. Inflation
over this period of time is an average of 2.618%.
Constant vs Actual Dollars
Example Problem – Done in Actual Dollars
Back in 1985 a US corporation is given $75 million dollars as a loan from a bank. In
2017, the same corporation writes a cheque back to the bank for the sum of $75
million in today's money and says the loan is payed off. What is actually going on in
this situation? What if the interest rate on the loan was 5% effective, yearly. Inflation
over this period of time is an average of 2.618%.
Constant vs Actual Dollars
• In general, when you look at a problem from different viewpoints the
solution shouldn't "actually" change.
• It may seem different, but for two different viewpoints to be
equivalent, both solutions must be transferable.
Constant vs Actual Dollars
• Can see that in the previous example, we can chose two
approaches:
• Option 1:
• All of the values in the cash flow diagram can be in real dollars (i.e. everything is
priced as it is in 1985. 75M vs getting paid back 39.8 M 32 years later You would
use i* at that point, and this is consistent with what we've been doing.
• Option 2:
• All cash flows are in actual dollars (ie, everything is priced as it would be in the
year it's bought) 75M (1985) vs getting paid back 75M (2017) 32 years later. You
would use i at that point, and this is not consistent with what we've been doing but
equivalent.
• CAN'T mix these two, so you CAN’T use real dollars with i.
• Which approach should we use?
Constant vs Actual Dollars
• Example: Cost effective vehicle - $10,000 in 1990, f=2% Cost of
insurance: $1000 per year, salvage value of $1000 (ten years later),
yearly operating cost of $200.

• Use i with actual dollars in cash flow, use i* with constant dollars
Constant vs Actual Dollars
• Example: Cost effective vehicle - $10,000 in 1990, f=2% Cost of
insurance: $1000 per year, salvage value of $1000 (ten years later),
yearly operating cost of $200.

• Use i with actual dollars in cash flow, use i* with constant dollars
Process for dealing with inflation
• Step 1: Determine what i, i*, f are in the problem

• Step 2: Determine which costs are real, and which ones are actual

• Step 3: Determine what you are trying to find?

• Value in a specific year for a simple problem?
• NPV or AW?

• Step 4: Select the analysis approach that is simpler:

• Use a diagram with all actual dollars and i, or
• Use a diagram with all constant dollars and i*
Example Problems
Problem 1: A firm wants to invest $10,000 of their capital with an investment company that
is giving them a return of 5.5% effective yearly, for 3 years. If inflation over this period is
2%, how much money will they have in 3 years? What is this worth in today’s purchasing
power?
Example Problems
Problem 2: A company wants to invest some money with an investment company that is
giving them a return of 5.5% effective yearly, for 3 years. They want to use this money to
purchase a cement mixer that costs $15,000 today. How much will they need to invest
today to have enough to buy the cement mixer in 3 years? Assume the inflation over this
period is 2%
Example Problems
Problem 3: The city of Winnipeg is looking to build a new active transit bridge over the red
river to connect south St. Mary’s blvd to the University of Manitoba to ease congestion.
The project is slated to cost $400k, and the last 20 years. A donor agrees to pay for the
bridge and also match the funds (so donates another 400k) so that a replacement bridge
can be built in 20 years. The city invests this for 20 years at a market interest rate of 5%
per year. If inflation averages 2% over the next 20 years:
A) How much donor’s funds be worth by the time the new bridge needs to be built vs. the
cost of the new bridge? Give this is both constant and actual figures.
B) Assuming the salvage value of the bridge is zero and there’s no maintenance costs for
the bridge, what is the NPV of this situation today?
Example Problems
Problem 3: The city of Winnipeg is looking to build a new active transit bridge over the red
river to connect south St.Marys to the University of Manitoba to ease congestion. The
project is slated to cost $400k, and the last 20 years. A donor agrees to match the funds
so that a replacement bridge can be built in 20 years and donates 400k to the city. The
city invests this for 20 years at a market interest rate of 5% per year. If inflation averages
2% over the next 20 years:
a) How much donor’s funds be worth by the time the new bridge needs to be built vs. the
cost of the new bridge? Give this is both constant and actual figures.
Example Problems
Problem 3: The city of Winnipeg is looking to build a new active transit bridge over the red
river to connect south St.Marys to the University of Manitoba to ease congestion. The
project is slated to cost $400k, and the last 20 years. A donor agrees to match the funds
so that a replacement bridge can be built in 20 years and donates 400k to the city. The
city invests this for 20 years at a market interest rate of 5% per year. If inflation averages
2% over the next 20 years:
b) Assuming the salvage value of the bridge is zero and there’s no maintenance costs for
the bridge, what is the NPV of this situation today?
Applying inflation in Engineering
• At this point the economics of inflation should be fairly straight
forward
• Some considerations:
• Engineering Rates: MARR, WACC, Cost of Capital
• Another measure that can make more sense when looking at inflation is the
MARR:Minimum Acceptable Rate of Return
• MARRc - Actual, i
• MARRr - Real, i*
• Engineering Costs:
• When doing research, costs can be in either actual or real dollars
• Some costs will be provided in different time spans
• Importance of quotes for engineering cost analysis
Inflation of other costs
• At this point we can solve a lot of inflation related problems as long
as we look at a inflation as a general term: the general inflation rate
applies to all items
• In reality however, this is rarely true:
• CPI was used to determine the general effect of inflation, but this only holds true
for some items
• PMI and other indices can be used to asses the inflation rate used for some items
• Trade, tarrifs, development, demand, and other factors can strongly influence the
price of many critical engineering goods.
• This has been recently of much more focus as more items are
sourced through a variety of international means and trade structures
• Two examples: emergent technology and building materials
Example Problems
Problem 4: An gas turbine engine overhaul facility is looking to outsource the rebuild of hot
sections for an older line of engines. There are three options they are looking at:
1. Outsourcing the overhaul to Company A, who is willing to sign a contract that indicates that they will do the
service for 250k per year
2. Outsourcing the overhaul to Company B who is willing to do this for 200k per year in today’s dollars
3. Outsourcing to company C who say they will do this for the next 4 years for a lump sum today of 800k.

Assuming you want to do this over 4 years with MARRc of 25% and an inflation rate of f =
3.5%, which option would you consider?
Example Problems
Problem 5: You're working on a design for a surgical table that is MRI compatible, and
requires you to use 316L stainless steel for the table top and Ti-6al-4V connectors. The
tables retail for $22,000 each (in today's dollars), and the material used varies in price.
Due to demand, the 316L stainless is expected to inflate at 5% per year (and you use a
total of $1200 of it per table). The titanium prices are on contract, however the amount you
use ($2000 per table in today's dollars) is expected to go up with inflation. You make 5
tables per year, inflation is estimated to be about 2% per year and your MARRc is 20%

A) What is i, i* and f in this situation?

B) What is your expected return over the next 5 years?

Example Problems
Problem 5:
A) What is i, i* and f in this situation?

B) What is your expected return over the next 5 years?

Understanding which approach to use
• By now, we can understand that most cash flows are composed of
two main components:
• Lump sump payments
• Annuities
• Of these two types of components, lump sum payments are typically
fairly easy to deal with from the inflation perspective:
• Any payment put on a diagram should either consistently corrected for inflation by
putting it in real dollars
• Or the other approach: all payments on the diagram should be in actual dollars.
• Both of these approaches are perfectly acceptable to use and
respectively use i* or i
Understanding which approach to use
• The annuities or series payments (if several are present) pose a greater
challenge: we want to avoid geometric (percent) gradients if possible.
• This leads use to characterize annuities by the following:

1. Annuities that reflect a series of constant dollar payments of equal value:

• Maintenance, Repair, Operating and similar costs that go up with time
• Recurring purchases, which would typically increase with inflation

2. Annuities that reflect a series of actual dollar payments of equal value:

• Contracts, payment plans, agreements, deferred payments

3. Annuities that reflect an actual increase different than inflation

• The choice of approach is based on which of these three is easiest to

solve for a given problem
Understanding which approach to use
1. Annuities that reflect a series of constant dollar payments of equal value:
• A project requires an up front cost of 200k, closedown cost at year 3 of 50k and a yearly maintenance cost
of 20k, what is the value of this project in today’s money?
Understanding which approach to use
2. Annuities that reflect a series of actual dollar payments of equal value:
• You looking at a contract for work that pays you a fixed 200k per year (contractually set so you get a deposit
of 200k each year for the work you’ve done). If you do this over the next 3 years, what is the value of this
contract?
Understanding which approach to use
3. Annuities that reflect an actual increase different than inflation
• You are looking to rent a house over the next 5 years, and the rental cost is 10k per year increasing by 5%
per year. If general inflation has been 2% per year and is expected to stay as such, what is the cost of this
rental over the 5 years in today’s money?
Applied Example Problem
You’re interested in buying a house and want to figure out what it will cost you to own over the next 25
years. You’ve spent 20 hours (at $50 per hour) of your time searching for a house, and paid a realtor
$200 to help you find the perfect house for you. The house has a value of 450k, and you need to pay a
land transfer tax of 1.3%, past due property tax of 1k, and legal fees of 0.9k. The down payment for the
house is 20% of the value, and the bank offers you a loan at 2.29% for 25 years such that your monthly
payments are $1.575k. If inflation is 2% and your personal cost of capital based on investments is ~8%
compounded yearly, what is the cost of this house to purchase in today’s money?
Learning Objectives
• Be able to correctly identify problems where inflation is a factor that
must be incorporated into analysis.
• Be able to distinguish between costs that are in constant/actual
dollars, and interest rates that are i* or i.

• Apply techniques of inflation analysis to simple cash flow problems to

solve for values in both actual and constant dollars.

• Be able to understand the effect of buying power on goods/materials

and incorporate this effect into analysis
• Be able to translate current skills in defining/solving economic
problems into a real world setting
Inflation
ENG 3000