Cash_Flows_and_the_Time_Value_of_Money

Convert interest rate to appropriate period or just

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Convert interest rate to appropriate period Or just be careful in analysis Cash Flows Occur More Frequently than Compounding Period Assume that money deposited between compounding periods does not earn interest Merely “aggregate” cash flows 50 Example Example Woodside Petroleum Ltd. is seeking approval from the Western Australian government for a A\$2 billion expansion of its North West Shelf liquefied natural gas facility. The new expansion would lift annual LNG output to around 16 million tons (from 11.7) by late 2008. Korea Gas Corp. (is looking to buy six million tons per year of LNG over two decades, starting in early 2008. Source: Bell, S. “UPDATE:Australia's Woodside Ready To Expand NW Shelf Gas,” Dow Jones Newswires , January 10, 2005.

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51 Example Assume weekly shipments (115,384 tons). If payments made on delivery and interest rate is 0.75% per month, what do you do? Aggregate (sum) payments to months. Assume monthly shipments (500,000 tons). If payments made on delivery and interest rate is.002% per day, what do you do? Convert interest rate to monthly rate. Or note 28, 30, or 31 compounding periods between payments. 52 Inflation Inflation Inflation and deflation affect cash flows and must be accounted for in analysis. Measure inflation with Price Index ratio of price of some commodity or service at some point in time to the price at some earlier point in time Price indices exist for numerous products, commodities, etc. CPI is most commonly known and used. ( )
53 Measuring Inflation One Period 1992: 140.3 1993: 144.5 f = CPI t + 1 CPI t CPI t f = 144.5 140.3 140.3 = .02993 = 2.99% 54 Measuring Inflation Measuring Inflation Multiple Periods Must include the effects of compounding. f is a periodic inflation rate. Look familiar? 1984: 103.7 1993: 144.5 CPI t + n = CPI t (1 + f ) n 144.5 = 103.7(1 + f ) 9 f = 144.5 103.7 1 9 1 = .0376 = 3.76%

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55 Purchasing Power Inflation erodes our purchasing power: the worth of our money. To analyze the loss of purchasing power, we can analyze cash flow diagrams with and without inflation. 56 Terminology Terminology Real Dollars: These dollars are NOT inflated. (Nominal or Constant.) Current Dollars: Are inflated – out of pocket money. (Future or Actual.) Market Interest Rate ( i ): Value includes inflation – rate that reflects opportunity for investments Inflation-Free (or Real) Rate ( i' ): Market rate with inflation effects removed Inflation Rate ( f ): Annual inflation rate