CHAPTER 14 PowerPoint Presentation 1-1
CHAPTER 14 PowerPoint Presentation 1-1
CHAPTER 14 PowerPoint Presentation 1-1
Chapter 14
Effects of inflation
Students Names
Cyrine Qaraqe /20190723/
Salah Boubes /20180157/
Hamza Boubes /20171585/
Mohammed Fayeq /20216522/
Supervisor Dactor
Dr. Mais Alzghool
Learning Outcomes
1. Understand inflation/deflation.
Money in one period of time t1 can be brought to the same value as money in
another period of time t2 by using the equation:
amount in period t2
Amount in period t1 =
inflation rate between t1 and t2
Using dollars as the currency, dollars in period t1 are called constant-value dollars
or today’s dollars. Dollars in period t2 are called future dollars or then-current
dollars and have inflation taken into account. If f represents the inflation rate per
period (year) and n is the number of time periods (years) between t1 and t2, the
equation will be:
future dollars
Constant-value dollars =
(1+ f )n
𝒊𝒇 = 𝒊 + 𝒇 + (𝒊)(𝒇)
Temporary price deflation can occur in specific economic sectors due to factors like
improved products or cheaper technology. This might lead to a short-term adjustment
in prices, but in normal situations, prices stabilize competitively. Deflation in a sector
can be orchestrated through dumping, as seen in the importation of materials at low
prices, impacting domestic manufacturers and potentially leading to inflation over
time. While moderate deflation may seem beneficial after prolonged inflation,
national-level deflation can lead to insufficient funds for new capital, reduced
spending capacity for individuals, and a generally tighter financial environment due to
fewer jobs, limited credit and fewer loans available; an overall “tighter” money
situation prevails.
Example: Constant Value Dollars
How much would be required to purchase an item that increased in cost by
exactly the inflation rate? The cost 30 years ago was $100 and inflation has
consistently averaged 4% per year.
NOTE: This calculation only account for the decreased purchasing power of the
currency. It dose not take into account the time value of money (to be
discussed).
Example: Market VS. Real Rate
Money in a medium-risk investment makes a guaranteed 8% per year. Inflation
rate has averaged 5.5% per tear. What is the real rate of return on the
investment?
𝑖𝑓 = 𝑖 + 𝑓 − 𝑖 (𝑓)
𝑖𝑓 − 𝑓
𝑖=
1+𝑓
0.08 − 0.055
𝑖= = 0.024 = 2.4%
1 + 0.055
Investment pays only 2.4% per year in real terms VS. the stated 8%
Present Worth Calculations Adjusted for
Inflation
Present Worth Calculations adjusted for inflation involve accounting for changes in
the value of currency over time. When determining the present worth of future cash
flows, it's crucial to consider the impact of inflation. This is typically done by
discounting future cash flows at a rate that reflects both the real interest rate
(adjusted for inflation) and the expected inflation rate. Adjusting for inflation
ensures a more accurate assessment of the actual purchasing power and value of
money over the investment period.
Present Worth Calculations Adjusted
for Inflation
1
P = 𝐹 (1+𝑖)𝑛
𝑖𝑓 = 𝑖 + 𝑓 + 𝑖 ∗ 𝑓
𝑖𝑓 : inflation-adjusted or market interest rate
𝑖 : real interest rate
f : inflation rate
If the cash flow is expressed in future dollars, the PW value is obtained using 𝑖𝑓 .
Present Worth Calculations Adjusted
for Inflation
A 15-year $50,000 bond that has a dividend rate of 10% per year, payable
semiannually, is currently for sale. If the expected rate of return of the
purchaser is 8% per year, compounded semiannually, and if the inflation rate
is expected to be 2.5% each 6-month period, what is the bond worth now:
(a) without an adjustment for inflation?
(b) when inflation is considered?
Present Worth Calculations Adjusted
for Inflation
(a) Without inflation adjustment: The semiannual dividend is
A = [(50,000)(0.10)]/2 = $2500.
At a nominal 4% per 6 months for 30 periods,
PW = 2500(P/A,4%,30) + 50,000(P/F,4%,30) = $58,645
"When you calculate future worth adjusted for inflation, you're accounting for
how the value of money changes over time. This means determining what a
certain amount of money in the future is really worth in today's terms,
considering the impact of inflation on its purchasing power."
Case 1: Actual Amount Accumulated It should be clear that F, the actual amount of money
accumulated, is obtained using the inflation-adjusted (market) interest rate.
𝑛
𝐹 = 𝑃 1 + 𝑖𝑓 = 𝑃(𝑓/𝑃, 𝑖𝑓 , 𝑛)
Case 2: Constant-Value Dollars with Purchasing Power The purchasing power of future
dollars is determined by first using the market rate i f to calculate F and then deflating the
future amount through division by 1 + 𝑓 𝑛
𝑛
𝑃 1 + 𝐼𝑓 𝑃(𝐹/𝑝, 𝑖𝑓 , 𝑛) 𝑖𝑓 − 𝑓
𝐹= = , 𝑊ℎ𝑒𝑛 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖 =
1+𝑓 𝑛 1+𝑓 𝑛 1+𝑓
Case 3: Future Amount Required, No Interest This case recognizes that prices increase
when inflation is present. Simply put, future dollars are worth less, so more are needed. No
interest rate is considered in this case—only inflation.
𝑛
𝐹 =𝑃 1+𝑓 = 𝑃(𝐹/𝑃, 𝑓, 𝑛)
Case 4: Inflation and Real Interest This is the case applied when a market MARR is
established. Maintaining purchasing power and earning interest must account for both
increasing prices (case 3) and the time value of money. If the growth of capital is to keep up,
funds must grow at a rate equal to or above the real interest rate i plus the inflation rate f.
FW Calculations with Inflation
The actual amount accumulated
The number of future dollars required to have same purchasing power as a dollar
today with no time value of money considered
The amount required to maintain the purchasing power of the present sum and
earn a stated real rate of return
Solution:
(c) The number of future dollars required to purchase goods that cost $15,000
now is the inflated cost of the goods
(d) In order to maintain purchase power and earn a real return, money must grow
by the inflation rate and the interest rate, or if = 13.4%, as in part (a)
FW = 15,000(F/P,13.4,10) = $52,750
Capital Recovery Calculations
Adjusted for Inflation
It is particularly important in capital recovery (CR) calculations used for AW
analysis to include inflation because current capital dollars must be recovered
with future inflated dollars. Since future dollars have less buying power than
today’s dollars, it is obvious that more dollars will be required to recover the
present investment
The A/P and A/F factors require the use of if when inflation is considered.
Example: AW with Inflation
If a small company invests $150,000 in a new production line machine, how
much must it receive each year to recover the investment in 5 years? The real
interest rate is 10% and the inflation rate is 4% per year.