1 / 22

Capital Budgeting and Financial Planning

Learn about inflation's impact on project cash flows, measurement, economic analysis, and terminology in capital budgeting and financial planning. Explore real vs. market interest rates and inflation-adjusted analysis in detail.

erickam
Download Presentation

Capital Budgeting and Financial Planning

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Capital Budgeting and Financial Planning Course Instructor: M.Jibran Sheikh Contact info: jibransheikh@comsats.edu.pk

  2. Inflation and Its Impact on Project Cash Flows • Meaning and Measure of Inflation • Equivalence Calculations under Inflation • Effects of Inflation on Project Cash Flows • Rate of Return Analysis under Inflation

  3. Inflation and Economic Analysis • What is inflation? • How do we measure inflation? • How do we incorporate the effect of inflation • in economic analysis?

  4. What is Inflation? • Value of Money • Earning Power • Purchasing Power Earning Power Purchasing power Investment Opportunity Decrease in purchasing power (inflation) Increase in purchasing Power (deflation)

  5. $100 $100 1990 2001 1990 Purchasing Power You could buy 50 Big Macs in year 1990. You can only buy 40 Big Macs in year 2001. 25% $2.00 / unit $2.50 / unit Price change due to inflation The $100 in year 2001 has only $80 worth purchasing power of 1990

  6. $100 $100 -2 -1 0 1 -2 -1 0 1 You can now purchase 80 gallons of unleaded gas. You could purchase 63.69 gallons of unleaded gasoline a year ago. 20.38% $1.57 / gallon $1.25 / gallon Price change due to deflation

  7. Price Increase Due to Inflation

  8. Inflation Terminology - I • Producer Price Index: a statistical measure of industrial price change, compiled monthly by the BLS, U.S. Department of Labor • Consumer Price Index: 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 • Average Inflation Rate (f): a single rate that accounts for the effect of varying yearly inflation rates over a period of several years. • General Inflation Rate ( ): the average inflation rate calculated based on the CPI for all items in the market basket.

  9. Measuring Inflation Consumer Price Index (CPI): the CPI compares the cost of a sample “market basket” of goods and services in a specific period relative to the cost of the same “market basket” in an earlier reference period. This reference period is designated as the base period. Market basket Base Period (1967) 2001 $100 $512.9 CPI for 2001 = 512.9

  10. Selected Price Indexes

  11. $112.32 0 1 2 $100 Average Inflation Rate (f) Fact: Base Price = $100 (year 0) Inflation rate (year 1) = 4% Inflation rate (year 2) = 8% Average inflation rate over 2 years? Step 1: Find the actual inflated price at the end of year 2. $100 ( 1 + 0.04) ( 1 + 0.08) = $112.32 Step 2: Find the average inflation rate by solving the following equivalence equation. $100 ( 1+ f) = $112.32 f = 5.98% 2

  12. Average Inflation Rate

  13. General Inflation Rate (f) Average inflation rate based on the CPI

  14. Example 13.2: Yearly and Average Inflation Rates What are the annual inflation rates and the average inflation rate over 3 years? Solution Inflation rate during year 1 (f1): ($538,400 - $504,000) / $504,000 = 6.83%. Inflation rate during year 2 (f2): ($577,000 - $538,400) / $538,400 = 7.17 %. Inflation rate during year 3 (f3): ($629,500 - $577,000) / $577,000 = 9.10%. The average inflation rate over 3 years is

  15. Inflation Terminology – II • Actual Dollars (An ): Estimates of future cash flows for year n that take into account any anticipated changes in amount caused by inflationary or deflationary effects. • Constant Dollars (An’ ): Estimates of future cash flows for year n in constant purchasing power, independent of the passage of time (or base period).

  16. 3 $1,000 (1 + 0.08) = $1,260 Conversion from Constant to Actual Dollars $1,260 $1,000 3 3 Actual Dollars Constant Dollars

  17. Conversion from Constant to Actual Dollars

  18. $130,000 $120,000 $110,000 $120,000 $100,000 0 1 2 3 4 5 Years (a) Constant dollars $250,000 $130,000(1+0.05)4 $120,000(1+0.05)5 $100,000(1+0.05) $120,000(1+0.05)3 $110,000(1+0.05)2 $250,000(1+0.05)0 $158,016 $138,915 $121,275 $153,154 $105,000 0 1 2 3 4 5 Years (b) Actual dollars $250,000

  19. -3 $1,260 (1 + 0.08) = $1,000 Conversion from Actual to Constant Dollars $1,260 $1,000 3 3 Actual Dollars Constant Dollars

  20. Conversion from Actual to Constant Dollars

  21. Equivalence Calculation Under Inflation 1. Types of Interest Rate 2. Types of Cash Flow 3. Types of Analysis Method Market Interest rate (i) Inflation-free interest rate (i’) In Constant Dollars In Actual Dollars Constant Dollar Analysis Actual Dollar Analysis Deflation Method Adjusted-discount method

  22. Inflation Terminology - III • Inflation-free Interest Rate (i’): an estimate of the true earning power of money when the inflation effects have been removed (also known as real interest rate). • Market interest rate (i): interest rate which takes into account the combined effects of the earning value of capital and any anticipated changes in purchasing power (also known as inflation-adjusted interest rate).

More Related