Effects of Inflation on
Project Cash Flows
Lecture No. 45
Chapter 11
Contemporary Engineering Economics
Copyright © 2006
Contemporary Engineering Economics, 4th
edition, © 2007
Effects of Inflation on Projects with
Depreciable Assets
Item
Effects of Inflation
Depreciation expense
Depreciation expense is charged to
taxable income in dollars of declining
values; taxable income is overstated,
resulting in higher taxes
Salvage value
Inflated salvage value combined with
book values based on historical costs
results in higher taxable gains.
Note: Depreciation expenses are based on historical costs and
always expressed in actual dollars
Contemporary Engineering Economics, 4th
edition, © 2007
Example 11.8

Reconsider the Automated Machining Center project
discussed earlier. What will happen to this
investment project if





the general inflation during the next five years is expected
to increase by 5% annually,
sales, operating costs, and working capital requirements
are assumed to increase accordingly,
depreciation will remain unchanged, but taxes, profits, and
thus cash flow will be higher.
the firm’s inflation-free interest rate is known to be 15%.
Determine the PW of the project.
Contemporary Engineering Economics, 4th
edition, © 2007
Example 11.8 Excel Worksheet
Depreciation deduction
does not increase over
time to keep pace with
inflation.
NPW = $38,899 > 0
Contemporary Engineering Economics, 4th
edition, © 2007
Effects of Borrowed Funds under
Inflation
Item
Effects of Inflation
Loan repayments Borrowers repay historical
loan amounts with dollars of
decreased purchasing power,
reducing the debt-financing
cost.
Contemporary Engineering Economics, 4th
edition, © 2007
Example 11.10 Effects of Inflation on Payments with
Financing
Inflation Rate
0
1
2
3
4
5
Income Statement
Revenues
Expenses:
Labor
Material
Overhead
Depreciation
Debt interest
The debt payment
size does not
change with inflation
5%
$105,000 $110,250 $115,763 $121,551 $127,628
5%
5%
5%
$ 21,000
$ 12,600
$ 8,400
$ 17,863
9,688
$ 22,050
$ 13,230
$ 8,820
$ 30,613
8,265
$ 23,153
$ 13,892
$ 9,261
$ 21,863
6,622
$ 24,310
$ 14,586
$ 9,724
$ 15,613
4,724
$ 25,526
$ 15,315
$ 10,210
$ 5,581
2,532
Taxable income
Income Taxes (40%)
$ 35,449
14,180
$ 27,272
10,909
$ 40,973
16,389
$ 52,593
21,037
$ 68,464
27,386
Net Income
$ 21,269
$ 16,363
$ 24,584
$ 31,556
$ 41,078
21,269
$ 17,863
16,363
$ 30,613
24,584
$ 21,863
31,556
$ 15,613
41,078
$ 5,581
Cash Flow Statement
Operating activities:
Net income
Depreciation
Investment activities:
Investment
Salvage
Gains tax
Financing activities
Borrowed funds
Princial repayment
Net Cash Flow
(in actual dollars)
Net Cash Flow
(in constant dollars)
Equ. Present Worth
Net Present Worth
(125,000)
5%
63,814
63,814
(12,139)
62,500
(9,179)
(10,601)
(12,244)
(14,142)
(16,334)
$ (62,500) $ 29,953
$ 36,375
$ 34,203
$ 33,027
$ 82,000
5%
$ (62,500)
$28,527
$32,993
$29,545
$27,171
$64,249
15%
$ (62,500)
$24,806
$24,948
$19,427
$15,535
$31,943
$54,159
Contemporary Engineering Economics, 4th
edition, © 2007
Effects of Inflation on Return on
Investment
Item
Rate of Return
and NPW
Effects of Inflation
Unless revenues are
sufficiently increased to keep
pace with inflation, tax effects
and/or a working capital drain
result in lower rate of return or
lower NPW.
Contemporary Engineering Economics, 4th
edition, © 2007
Rate of return Calculation in the
Absence of Inflation
MARR = 20%
IRR’ = 21.88%
The investment
is acceptable.
Contemporary Engineering Economics, 4th
edition, © 2007
Rate of Return Calculation under
Inflation
MARR = 20%
IRR’ = 19.40%
The investment
is no longer
acceptable.
Contemporary Engineering Economics, 4th
edition, © 2007
Rate of Return Analysis under Inflation
_
f  10%


Principle:True (real) rate of
return should be based on
constant dollars.
If the rate of return is
computed based on actual
dollars, the real rate of
return can be calculated
as:
i' 
1 i
_
1
1 f
1  0.3134

1
1  0.10
 19.40%
n
0
1
2
3
4
Net cash
flows in
actual
dollars
-$30,000
13,570
15,860
13,358
13,626
IRR
31.34%
Not correct IRR
Contemporary Engineering Economics, 4th
edition, © 2007
Net cash
flows in
constant
dollars
-$30,000
12,336
13,108
10,036
9,307
19.40%
Decision Criterion


If you use 31.34% as your IRR, you should
use a market interest rate (or inflationadjusted MARR) to make an accept and
reject decision.
If you use 19.40% as your IRR, you should
use an inflation-free interest rate (inflationfree MARR) to make an accept and reject
decision. In our example, MARR’ = 20%.
Contemporary Engineering Economics, 4th
edition, © 2007
Effects of Inflation on Working Capital
Item
Working capital
requirement
Effects of Inflation
Known as working capital
drain, the cost of working
capital increases in an
inflationary environment.
Contemporary Engineering Economics, 4th
edition, © 2007
Example 11.12 (a) Without Inflation
Contemporary Engineering Economics, 4th
edition, © 2007
Example 11.12 (b) With Inflation
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Working Capital Requirements under
Inflation
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edition, © 2007
Summary
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The Consumer Price Index (CPI) is a statistical
measure of change, over time, of the prices of
goods and services in major expenditure
groups—such as food, housing, apparel,
transportation, and medical care—typically
purchased by urban consumers.
Inflation is the term used to describe a decline
in purchasing power evidenced in an economic
environment of rising prices.
Deflation is the opposite: An increase in
purchasing power evidenced by falling prices.
Contemporary Engineering Economics, 4th
edition, © 2007

The general inflation rate (f) is an average
inflation rate based on the CPI. An annual
general inflation rate ( f ) can be calculated using
the following equation:
CPI n  CPI n1
fn
CPI n 1

Specific, individual commodities do not always
reflect the general inflation rate in their price
changes. We can calculate an average inflation
rate for a specific commodity (j) if we have an
index (that is, a record of historical costs) for that
commodity.
Contemporary Engineering Economics, 4th
edition, © 2007


Project cash flows may be stated in one of two
forms
Actual dollars (An): Dollars that reflect the
inflation or deflation rate.
Constant dollars (A’n): Year 0 dollars
Interest rates for project evaluation may be
stated in one of two forms:
Market interest rate (i): A rate which combines
the effects of interest and inflation; used with
actual dollar analysis
Inflation-free interest rate (i’): A rate from
which the effects of inflation have been removed;
this rate is used with constant dollar analysis
Contemporary Engineering Economics, 4th
edition, © 2007

To calculate the present worth of actual dollars,
we can use a two-step or a one-step process:
Deflation method—two steps:
1. Convert actual dollars by deflating with the
general inflation rate of f
2. Calculate the PW of constant dollars by
discounting at i’
Adjusted-discount method—one step
1. Compute the market interest rate.
2. Use the market interest rate directly to find
the present value.
Contemporary Engineering Economics, 4th
edition, © 2007