Engineering Economic Analysis

Problems 465

purchasing power than those originallyborrowed. This condition is advantageousto lenders

at the expense of borrowers. Inflation and deflation have opposite effects on the purchasing

power of a monetary unit over time.

To distinguish and account for the effect of inflation in our engineering economic

analysis, we defineinflation, real,andmarketinterest rates. These interest rates are related

by the following expression:.

i=if+f +iff

Each rate applies in a different circumstance, and it is important to apply the correct rate to

the correct circumstance. Cash flows are expressed in term.sof eitheractualorreal dollars.

Themarket interestrate should be used withactual dollarsand thereal interest rateshould

be used withreal dollars.

The different cash flows in our analysis may inflate or change at different interest

rates when we look over the life cycle of the investment. Also, a single cash flow may

inflate or deflate at different rates over time. These two circumstances are handled easily by

applying the appropriate inflation rate to each cash flow over the study period to obtain the

actual dollar amounts occurring in each year. After the actual dollar quantities have been

calculated, the analysis proceeds, as in earlier chapters, utilizing the market interest rate to

calculate the measure of merit of interest..

Historical price change for single commoditiesand bundles of commoditiesare tracked

with price indexes. The Consumer Price Index (CPI) is an example of a composite index

formed by a bundle of consumer goods. The CPI serves as a surrogate for general inflation

in our economy. Indexes can be used to calculate theaverage annual increase(or decrease)

of the costs and benefits in our analysis. The historical data provide valuable information

about how economic quantities may behave in the future over the long run.

The effect of inflation on the computed rate of return for an investmentdepends on how

future benefits respond to the inflation. If benefits produce constant dollars, which are not

increased by inflation, the effect of inflation is to reduce the before-tax rate of return on the

investment. If, on the other hand, the dollar benefits increase to keep up with the inflation,

the before-tax rate of return will not be adversely affected by the inflation. This outcome is

not found when an after-tax analysis is made. Even if the future benefits increase to match

the inflation rate, the allowable depreciation schedule does not increase. The result will be

increased taxable income and income tax payments, which reduce the available after-tax

benefits and, therefore, the after-taxrate of return. The importantconclusionis thatestimates

of future inflationor deflationmay be important in evaluatingcapital expenditureproposals.

BLEMS

fine inflation in tenns of the purchasing power of
lars.
line and describe the relationships between the
owing: actual and real dollars; and inflation, real
!market (combined) interest rates.

14-3 How does inflationhappen-describe a few circum-

stances that cause prices in an economyto increase.

14-4 Is it necessary for inflation to be accounted for in

an engineering economy study? What are the two

approaches for handling inflation.insuch analyses?

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