Engineering Economic Analysis

448 INFLATION AND PRICECHANGE

Obviously, either option would have been better than the choice Mr. O'Leary made. This

example illustrates the effects of inflation and purchasing power, as well as the power of

compounded interest over time. However, in Mr. O'Leary's defense, if the United States

had experienced 70 years ofdeflationinstead ofinflation,he might have had the last

laugh!

There are in general two ways to approach an economic analysis problem after the

potential effects of inflation have been recognized. The first is to conduct the analysis by

systematicallyincludingthe effectsof inflation;the secondis to ignore the effectsof inflation

in conducting the analysis. Each case requires a different approach.

Incorporating inflation in the analysis: Use amarket interest rate and actual dollars

that include inflation.

Ignoring 'inflation in the analysis: Usereal dollars and areal interest ratethat does

not reflect inflation.

Analysis in Constant Dollars Versus Then-Current Dollars

Performing an analysis requires that we distinguish cash flows as being either constant

dollars (real dollars, expressed in terms of some purchasing power base) or then-current

dollars (actual dollarsthat are then-currentwhen they occur). As previously stated, constant

(real) dollars require the use of areal interest ratefor discounting, then-current dollars

require amarket (or combined) interest rate.It is not appropriate to mix these two dollar

types when performingan analysis.If both types are stated in the problem, one must convert

either the constant dollars to then-current dollars or the then-current dollars to constant

dollars, so that a consistent comparison can be made.

'(heWayg!<1teCorporationis interestedin evaluatingamajor new video d!splaytechnology (VDT).

Two competing computer innovationc:o!llpanieshave approached Waygate to develop the tech-

nologyfor the new VDT. Waygate believes thatboth companies will.be able to deliver equivalent

products at the end of a 5,.yearpeli,od..Eromthe yearly development costs of theVD'r foJ."each

ofihe two companies as given, detenjUnewhich Waj'gate shotildcboose.if the c0IJ.?0rateM1\RR

(in}{estmeJ1t.marketrate) .is 25%apd geJ1era.lpqcejnfla.nolli.s~sumed tope 3.5% perj'ear over

the'mext5 years.

tl..:_" _'''' ",'-', _ " __.,',." ',' _' .',_."'- _',,'__,,',' _ _ _.<'"

IICQmpany Alpha costs: DeveloP.lJleJ1t costs Will he $15Q;OOOtlIe'firstyeaJ.". ap.d W.mincrease

~ ;!::.:~ at,arate ot.5% oYeJ;'tbe~Ye~I!eriog! ~.;;: ~~ ~ == ~ ~ ,= = ~ '.;;:~ =:: = = ':I'\':

0_.

::CQmpany Be-faco~ts:DeveI9~J:l1ehtJcostswill bea COll$t!!Il.t'$1'5Q,OOO'petj'eMipte11Il$of.

" ','loday's dollars over the5'C"Yea.r~,. , I

r=E==,rZ ~ ~~ ~== ~-, l1' " .-=,: == III ;:;f- ==-~-;:;;;;:; ~