Accounting for Inflation

# Accounting for Inflation - A ccounting f or I nflation L et...

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-- / Accounting for Inflation Let us now consider a problem where the service lives of two alternative capital projects are of different lengths. Project 1 Project 2 initial cost \$50,000 \$120,000 expected life 20 years 40 years salvage value \$10,000 \$20,000 annual cost \$9,000 \$7,250 The discount rate is 11% and the planning horizon is 40 years. We can either do the first project twice consecutively, or the second project once. (Actually in 20 years time there may be other alternatives, but we can only compare what we know about now. ) Assuming the projects are equally effective, we want to compute the present value of each project's total cost. Project 1 Project 2 Initial Cost \$50,000 \$120,000 Replacement Cost \$50,000-\$10,000 o xSPPWF(20)=\$4,961 piA Annual Cost \$9,000xUSPWF \$7,250xUSPWF =\$80,560 =\$64,895 Salvage Value \$10,000xSPPWF(40) \$20,000xSPPWF(40) =\$154 =\$308 \$135,367 _ \$184,587 /

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NPW C1 - NPW c 2 = \$49,220, where SPPWF(11%,20yrs)=0.124, SPPWF(11%,40yrs)=0.0154, USPWF(11%,40yrs)=8.951 Now, we haven't taken account of inflation, which can affect the replacement costs and salvage values. Under what conditions is it per.missible to dismiss considerations of inflation? When we can reduce payment streams to annual equal payments or when all benefits and costs are inflated by the same amount. How can we incorporate inflation into our calculations when it is appropriate to consider it? Given a single payment F (quoted in current dollars), the inflation factor is (l+i)n, the discount factor is (l+d)n, hence the discounted inflation factor is (l+i)n/(l+d)~[(l+i)/(l+d)]n. The
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Accounting for Inflation - A ccounting f or I nflation L et...

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