Engineering Economic Analysis

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450 INFLATION AND PRICECHANGE

Year

1

2

3

4

5

Then-Current Costs

Stated by Alpha

$150,000 x (1.05)° = $150,000

150,000 x (1.05)1 - 157,500

150,000 x (1.05)2 165,375

150,000 x (1.05)3 = 173,644

150,000 x (1.05)4= 182,326

Then-Current Costs

Stated by Beta

$150,000 x (1.035)1=$155,250

150,000 x (1.035)2 = 160,684

150,000 x (1.035)3= 166,308

150,000 x (1.035)4= 172,128

150,000 x (1.035)5= 178,153

Calculate the present worth of costs for each alternative using themarket interest rate (i).

PW of cost (Alpha) = $150,000(P I F,25%, 1) +$157,500(P I F,25%, 2)

+ $165,375(P I F,25%,03)+'$173,644(P j F,25%, 4)

• $182,326(P I F,25%, 5) ".$436,000

PW of cost (Beta) =$155,250(PIF,25%,1) +$160,684(P I F,25%, 2)

+ $166,308(P I F,25%, 3)+ $172,128(P I F,25%, 4)

+$178,153(PjF, 25%, 5)=$441,000

USing either a constant dollar or then-current dollar analysis Waygate should chose Company

Alpha's offer, which has the lower present worth of costs. There may, of course, be intangible

elements in the decision making that also should be considered.

PRICECHANGE WITH INDEXES

We have already described the effects that inflation can have on money over time. Also,

severaldefinitions and relationshipsregarding dollars and interest rates have been given.We

have seen that it is not appropriate to compare the benefits of an investment in 2004-1;>ased

dollars against costs in 2006-baseddollars. This is like comparing apples and oranges. Such

compariS'8f1g~fbenefits and costs can be meaningful only if a standard purchasing power

base of money is used. An often asked question is, How do I know what inflationrate to use

in my studies?This is a valid question.What can we use to measureprice changes overtime?

What Is a Price Index? Price Change with Indexes 450 --.

Price indexes are used as a means to describe the relative price fluctuation of goods and

services in our national economy. They provide ahistoricalrecord of the behavior of

these quantities over time. Price indexes are tracked forspecific commoditiesas.well as

forbundles (composites) of commodities.As such, price indexes can b~ used to measure

historical price changes for individual cost items (like labor and material costs) as well

as general costs (like consumer products). In understanding the past price fluctuations we

have more information for predicting the future behavior of those cash flows.