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INFO 631 Prof . Glenn Booker

INFO 631 Prof . Glenn Booker. Week 5 – Chapters 13-15. Inflation and Deflation. Chapter 13. Inflation and Deflation Question. Think about the last time you bought something you’ve bought before How much did you pay? How much did you pay the first time it was bought?

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INFO 631 Prof . Glenn Booker

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  1. INFO 631Prof. Glenn Booker Week 5 – Chapters 13-15 INFO631 Week 5

  2. Inflation and Deflation Chapter 13 INFO631 Week 5

  3. Inflation and DeflationQuestion • Think about the last time you bought something you’ve bought before • How much did you pay? • How much did you pay the first time it was bought? • Was it the same price both times? • Most likely not • Prices change over time • Short term • Long-term INFO631 Week 5

  4. Inflation and DeflationOutline • Inflation and deflation, defined • Price indices, Consumer Price Index, Produce Price Index • Inflation rate • Purchasing power and inflation • Accounting for inflation INFO631 Week 5

  5. Inflation and Deflation • Refer to long-term trends in prices • Inflation  same things cost more than before • Deflation  same things cost less than before • Generally refer to the overall economy, not specific products and services • Long term changes in the “purchasing power” of money • Tendency for inflation over last 50+ years but significant deflation has happened • Note: General trend in 1800’s was deflation (caused by industrial revolution), INFO631 Week 5

  6. Possible Causes - Inflation and Deflation • Inflation • Government price support polices (subsidies) • Deficit spending • Higher production costs • Wage increase of workers • Lower availability of resources • Deflation • More efficient production methods • Lowers production cost • Higher availability of resources INFO631 Week 5

  7. Average Relative Price Level (CPI), 1913-2002 NOTE: Shows a substantial change in relative prices over time. Something that sold for about 10 cents in 1910 would go for nearly $2 today. INFO631 Week 5

  8. So what does it mean to us? • If planning horizon is long or high annual inflation rate • Can cause noticeable change in value of proposal • Might need to address during decision • If planning horizon is short or inflation is weak • Might be able to just ignore • Overall it is a judgment call on the decision makers part INFO631 Week 5

  9. Price Indices:- Measuring Inflation and Deflation • Ratio (expressed as percentage) of historical price to price at another time • Example • Gas in 2005 ($2.00) vs. gas in 1999 ($1.40) INFO631 Week 5

  10. Creating a Price Index • Define a “market basket” • Reference shopping list with kinds and amounts • Choose a reference date • Price the market basket on the reference date • Price the market basket today • Price index = ratio of current price to price on reference date INFO631 Week 5

  11. Common Price Indices • Consumer Price Index (CPI) • Change from retail purchase’s perspective • Producer Price Index (PPI) • Change from sellers perspective • Complied by Department of Labor and Department of Commerce INFO631 Week 5

  12. Consumer Price Index (CPI) • Measures price change from retail purchaser’s perspective • Based on spending habits of average household consumer • Market basket of about 400 goods and services • Housing • Food and beverage • Apparel • Transportation • Medical care • Recreation • Education • Utilities and fuels, etc. • Reference date for CPI isn’t a single point in time • Based on average of three years (1982-1984) INFO631 Week 5

  13. Producer Price Index (PPI) • Family of price indices • Measures change in selling prices for domestic goods and services before they reach the retail consumer • Used for adjusting business-to-business contracts for inflation (long term) • Prices to be paid for in the future • Over 500 industry-level price indices and 10,000+ specific product line and product category sub-indices • Manufacturing, Agriculture, Forestry, Fisheries, Mining, Scrap, … • Transportation, Utilities, Finance, Business services, Health, Legal, Professional services, … INFO631 Week 5

  14. Inflation Rate • Measures rate of increase of corresponding price index • Usually stated as an annual percentage • Deflation rate is negative inflation rate • 1.4% deflation = -1.4% inflation INFO631 Week 5

  15. Single-Year Annual Inflation Rate • Examples CPI (1966) = 32.4 CPI (1965) = 31.5 CPI (2000) = 172.26 CPI (1999) = 166 INFO631 Week 5

  16. Annual Inflation Rate, 1914 - 2002 INFO631 Week 5

  17. Average Annual Inflation Rate • Example CPI (1999) = 166.6 CPI (1990) = 130.7 Note:For decisions spanning over 1 year, use Average Inflation Rate applied over entire planning horizon. INFO631 Week 5

  18. Purchasing Power and Inflation • Inflation means • Purchasing power if money is going down. • “Same amount of money later on doesn’t buy as much as it did before” • Inflation rate – tells how much more is • Purchasing Power means • “How much can I buy for a given amount” • Example • 1970 candy bar = 25 cents • 1997 = $1.00 • Purchasing power and inflation are closely related but not equivalent INFO631 Week 5

  19. Purchasing Power K = PurchasingPoweryear(1) = PriceIndexyear(0) ------------------ PriceIndexyear(1) K = PurchasingPower1976 = PriceIndex(1975) = 53.8 ------------------ ------ = 0.946 PriceIndex(1976) 56.9 Means: it would take $1 (end 1976) to buy same goods that could be bought for 94.6 cents (end 1975) INFO631 Week 5

  20. Purchasing Power and Inflation • Average loss in purchasing power over multiple years • Example Average annual loss in purchasing power was 2.4% in the ’90s INFO631 Week 5

  21. Purchasing Power and Inflation • Purchasing power and inflation are closely related but not equivalent • Example Note: f-bar (annual inflation rate) thru 1990’s (above) and k-bar (average loss in purchasing power) thru 1990’s (above) INFO631 Week 5

  22. Recap - Purchasing power and inflation • Purchasing power and inflation are closely related but not equivalent • Use Inflation rate when • Ask “How much will <x> cost at <time>?” • Use Purchasing Power when • Ask “How much can I buy for <amount of money> at <time>?” INFO631 Week 5

  23. Accounting for Inflation Two Methods • Actual dollar analysis • Cash-flow instances represent actual out-of-pocket dollars paid/received at that time • A.k.a. current dollars, escalated dollars, inflated dollars, … • Constant dollar analysis • Cash-flow instances represent hypothetical constant purchasing power amounts • A.k.a. real dollars, deflated dollars, today’s dollars, … INFO631 Week 5

  24. Actual-Constant Dollar Analogy INFO631 Week 5

  25. Converting Actual Dollars to Constant Dollars • Example Note: Remember we calculated earlier that f-bar thru the ’90s was 2.46%. $12.95 in 1995 was worth the same as $11.47 in 1990. INFO631 Week 5

  26. Converting Constant Dollars to Actual Dollars • Example Note: Remember we calculated earlier that f-bar thru the ’90s was 2.46%. So $12.95 in 1990 was worth the same as $14.63 in 1995. INFO631 Week 5

  27. Actual Dollar vs. Constant Dollar Analysis • f is the inflation rate (speed of current in river) • i is the market interest rate (speed of boat through water) • i’ is the inflation-free interest rate (speed of boat relative fixed point) INFO631 Week 5

  28. Relationship Between Actual and Constant Dollar Analysis INFO631 Week 5

  29. Simple Example of Actual and Constant Dollar Analysis At 7% market interest, $10k grows to $19,670 after 10 years—this is actual dollars At 3.88% inflation-free interest, $10k grows to be worth $14,603 base-year dollars in year 10—this is constant dollars Note that $19,670 actual dollars in year 10 = $14,630 constant dollars. INFO631 Week 5

  30. Key Points • Inflation refers to long-term increases in prices • A price index is the ratio of the price at one time to the price at another • The inflation rate is the rate of increase in a price index • Purchasing power and inflation are related but different • Inflation can be addressed using actual dollar or constant dollar analysis INFO631 Week 5

  31. Depreciation Chapter 14 INFO631 Week 5

  32. DepreciationOutline • Introducing depreciation • Value-time functions • Book value • Depreciation methods • Before 1981 • 1981 through 1986 • 1987 and beyond • Units-of-production depreciation INFO631 Week 5

  33. Depreciation • Depreciation addresses how investments in capital assets are charged off against income over several years • Important part of calculating after-tax cash flow INFO631 Week 5

  34. Introducing Depreciation • Two different meanings • Actual depreciation • How an asset loses value over time • Physical depreciation • Literally means asset is wearing out • Wear and tear, etc. • Functional depreciation • Environment where asset is operating has changed and asset is not well matched to the new environment. • Obsolescence • Depreciation accounting • How the organization accounts for that loss in value • Note: • Actual deprecation (real loss in value) is rarely the same as depreciation accounting (how loss accounted for by organization). • For actual depreciation – need to sell asset and see what someone will pay for it INFO631 Week 5

  35. Key Ideas in Depreciation Accounting • Corporations are taxed on profit, not income • Profit = Income - Expenses • Expenses claimed in a tax year should reflect actual expenses incurred • Including actual depreciation, as best as it can be estimated • Tax authorities are trying to force accounting and recognition of an asset’s loss in value to be as close as possible to when that loss actually happens (make each years income tax as realistic as possible) • Alternatives to depreciation • Write off in year of acquisition • Write off in year of disposal INFO631 Week 5

  36. Key Ideas in Depreciation Accounting (cont) • Depreciation amounts aren’t actual cash-flow instances • Actual cash flow happened on acquisition • Depreciation amounts are allocation of actual expense over time • Force company to spread recognition of original expense over asset’s assumed life • Depreciable assets (required to be treated as): • Used in business or trade • Used for producing income • Have a known lifespan >1 year INFO631 Week 5

  37. Value-Time Function • Mathematical function that models how an asset loses value over time • Two types • Straight-line • Simplest • Asset loses value at a constant rate • Declining value • Asset loses value as a fixed percentage of its remaining value over its lifetime. INFO631 Week 5

  38. Value-Time Function Straight-line Declining-balance INFO631 Week 5

  39. Book Value • Tax authorities’ best estimate—based on depreciation accounting—of an asset’s actual value • May or may not reflect the true value INFO631 Week 5

  40. Depreciation Methods Note: Method stays until disposal – doesn't change with laws • Before 1981 • Straight-line • Declining-balance • Declining-balance switching to straight-line • Sum-of-the-years-digits • 1981 through 1986 • Accelerated cost recovery system (ACRS) • 1987 and beyond • Modified accelerated cost recovery system (MACRS) INFO631 Week 5

  41. Why Care About Old Methods • Broad survey of different methods • Good foundation for today’s method • When laws change, old method might come back to use • You never know…… INFO631 Week 5

  42. Depreciation Methods • Before 1981 company could choose • Straight-line • Declining-balance • Declining-balance switching to straight-line • Sum-of-the-years-digits • Steps • Choose method • Estimate asset useful life • Based on organizations past history • Class life asset depreciations range (CLADR) • See book pg 217, Figure 14.1 • IRS approved useful life range INFO631 Week 5

  43. CLADR System • “Class Life Asset Depreciation Range” • Defined lower, recommended, and upper limits on asset life spans • Business aircraft: 5, 6, 7 years • Autos & taxis: 2.5, 3, 3.5 years • Agriculture equipment: 8, 10, 12 years • Computers: 5, 6, 7 years • Furniture: 8, 10, 12 years • … Note: IRS likes recommended (ADR) INFO631 Week 5

  44. Straight-line Depreciation • Assumes value of asset decreases at constant rate over its useful life • Asset loses fixed percentage of original value each year INFO631 Week 5

  45. Example of Straight-line Depreciation • Example asset • Acquisition cost = $34,000 • Salvage value = $2000 • Useful life = 5 years = n End of Depreciation Book Value at Year in that year end of year 0 -- $34,000 1 $6400 $27,600 2 $6400 $21,200 3 $6400 $14,800 4 $6400 $8,400 5 $6400 $2,000 INFO631 Week 5

  46. Declining-Balance Depreciation • Value decreases at fixed percentage of remaining (book) value over useful life • Depreciation amount is based on fixed percentage of book value (a) (a = 2/n, n=years) • Double declining-balance means a = 2/n • 150% declining-balance means a = 1.5/n INFO631 Week 5

  47. Example of Declining-balance Depreciation • Same asset • Double declining-balance, a = 2/5 = 0.40 End of Depreciation Book Value at Year in that year end of year 0 -- $34,000 1 0.40 * $34,000 = $13,600 $20,400 2 0.40 * $20,400 = $8160 $12,240 3 0.40 * $12,240 = $4896 $7344 4 0.40 * $7344 = $2938 $4406 5 0.40 * $4406 = $1763 $2644 INFO631 Week 5

  48. Example of Declining-balance Depreciation • Same asset • 150% declining-balance, a = 1.5/5 = 0.30 End of Depreciation Book Value at Year in that year end of year 0 -- $34,000 1 0.30 * $34,000 = $10,200 $23,800 2 0.30 * $23,800 = $7140 $16,660 3 0.30 * $16,660 = $4998 $11,662 4 0.30 * $11,662 = $3499 $8163 5 0.30 * $8163 = $2449 $5714 INFO631 Week 5

  49. Declining-balance Switching to Straight-line Depreciation • Declining-balance used initially • Switch to straight-line when declining-balance amount is less than straight-line amount • Mathematically – when slope of declining-balance curve becomes less then slope of straight line. INFO631 Week 5

  50. Declining-balance Switching to Straight-line Depreciation (cont) Note: Ignores salvage value INFO631 Week 5

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