Inflation rates

Inflationary Effects. Inflation can have a significant effect on the profitabiUty of a venture. However, the U.S. federal tax laws do not allow for indexing the inflationary effects on depreciation schedules, salvage values, replacement costs, or taxable income. Inflation rates can vary unpredictably with time and can differ for certain revenues of expenditures. 

Prevailing interest rates probably tend to reflect an estimate of future inflation and contain a component that can be attributed loosely to inflationary expectations. However, the classical treatment is to assume that an inflation-free interest rate, r and average inflation rate, r, over the project lifetime can be identified. A discount factor (1 + r) can be modified (25) so that... 

Published figures for inflation rates are based on some particular mixture of goods and sei vices that is chosen to represent the material wants of the average citizen. If a given quantity of this specific mixture cost 100 last year and now costs 120, then the mix has suffered a 20 percent rate of inflation. The purchasing power of the currency (i.e., of the 120) in respecl of these goods and sei vices has consequently fallen by a factor of ( 120 — 100)/ 120, or 16.7 percent. 

Equation (9-110) enables all the net annual cash flows to be corrected to their purchasing power in Year 0. If the inflation rate is zero, Eq. (9-110) becomes identical with Eq. (9-109). 

Let us modify this example by assuming that there is a general inflation rate of 20 percent per year and that the project analyst ignores the inflation and (inappropriately) applies Eq. (9-109). The revenue and expense data for this case are shown in Table 9-15, yielding an (NPV) of 431,269. When Eq. (9-109) is (inappropriately) used for the same example with various other rates of inflation, the resulting (NPV)s can be plotted as the upper line in Fig. 9-29. 

Table 9-15 shows that the total amount of tax actually paid over the 5-year period was 988,320. This becomes 5.34,272 in uninflated-money terms when the tax for each year is corrected to its purchasing power in Year 0, using / factors for the 20 percent inflation rate employed for the example. Calculations for other rates of inflation can also be made, and the results plotted as in Fig. 9-.30. 

This confirms that although the tax paid will increase with inflation, the gain to the government is more apparent than real. It is interesting to note that although the tax paid corrected to its purchasing power in Year 0 is almost constant irrespective of the inflation rate, it does go through a maximum at an inflation rate of about 17 percent in this example. 

FIG. 9-29 Effect of inflation rate on net present value for a project. 

Instead of using Eq. (9-113), it is unfortunately common practice to try to obtain the true or effective rate of return by calculating the nominal (DCFRR), based on actual net annual cash flows uncorrected for inflation, and then subtracting the inflation rate from it as if... 

Equation (9-113) shows that Eq. (9-114) is only approximately true and should be used, if at all, solely for low interest rates. Let us consider the case of a nominal (DCFRR) of 5 percent and an inflation rate of 3 percent. Equation (9-14) yields an approximate effective return rate of 2 percent, compared with the real effective rate of 1.94 percent given by Eq. (9-113) i.e., there is an error of 3.1 percent. Now let us consider the case of a nominal (DCFRR) of 2.5 percent and an inflation rate of 23 percent. Equation (9-114) yields an approximate effective return rate of 2 percent, compared with 1.63 percent from Eq. (9-113) in this case, the error that results is 22.7 percent. 

FIG. 9-31 Effect of inflation rate on the relationship between the payback period and the discounted-cash-flow rate of return. 

The magnitude of the effect comes through even more clearly in Fig. 9-32, a plot of the time needed to reach a nominal (DCFRR) of 20 percent against the inflation rate for various values of (PBP). This plot also shows that the longer the payback period, the greater the increase in apparent profitability of the project. 

The true rates of return L can be calculated from Eq. (9-116) to be 20, 9.09, 0, and —7.69 percent respec tively for generaf inflation rates of 0, 10, 20, and 30 percent. Thus, although the time required for a projec t with a payback period of 4 years to reach a nominal (DCFRR) of 20 percent is reduced from almost 9 years under conditions of no inflation to less than 3V2years for 30 percent inflation, the true rate of return that prevails for the latter condition is —7.69 percent, implying that the project loses money in real terms. 

It is interesting to note that, in order to reach a real (DCFRR) or of 20 percent within a reasonable project hfetime when the general inflation rate is 20 percent, it follows from Fig. 9-31 that the payback period for the project must not be much in excess of 2 years. 

Although it is difficult to carry out economic-feasibility studies on projec ts in a time of high inflation, it is important to try to predict inflation rates and allow for them in such studies. 

Let us consider the effect of differential inflation on the overall profitability of the project of the last example. The effect of general inflation on this project showed that the apparent profitability rises sharply, to an (NPV) of 431,269 at a general inflation rate of 20 percent. However, when the cash flows of the (NPV) are properly corrected to their purchasing power in Year 0, the (NPV) instead becomes 208,733. 

If the fractional inflation rate is a fractional interest rate on a loan can be corrected to an effective rate of interest by Eq. (9-116) with ii substituted for (DCFRR). The effect of various amounts of loan, borrowed at various interest rates ii, on the net present value of a particular, fairly simple project is shown in Fig. 9-37. Thus, if 25,000 were borrowed at an interest rate of 15 percent for the project, the (NPV) would be about 43,000 at a zero inflation rate. But if the inflation for goods and services i, is 10 percent, the effective interest rate for that loan can be calculated from Eq. (9-116) to be only 4.55 percent. It is seen from Fig. 9-37 that this increases the (NPV) of the project to 48,000. This confirms the economic advantage of borrowing at a fixed interest rate in a time of general inflation. 

This is independent of inflation provided that the cost of gas rises in line with any general rate of inflation. However, if the real cost of gas rises at a fractional annual rate r over and above the general inflation rate, it should be modified into the form... 

Equity holders require a real return on their outlay, which they assume to be at the stock-market price if this differs from the face value of the stock, of 7 percent net of all taxes. Retained earnings attract a 40 percent capital gains tax hence the actual interest rate required on distribution forgone is 7/(1 — 0.40) = 11.67 percent. This is in real terms and at a time of 8 percent inflation rate must be increased in cash terms to (1 -I- 0.1167)(1.08) — 1 = 20.60 percent. 

The tables were based upon the cost of energy at the end of the first year, a 10 percent inflation rate on energy costs, a 15 percent interest cost, and a present-worth pretax profit of 40 percent per annum on the last increment of insulation thickness. Dual-layer insulation was used for 3l/2-in and greater thicknesses. The tables and a full explanation of their derivation appear in a paper by F. L. Rubin (op. cit.). Alternatively, the selected thicknesses have a payback period on the last nominal l/2-in increment of 1.44 years as presented in a later paper by Rubin [ Can You Justify More Piping Insiilation Hydrocarbon Process., 152-155 (July 1982)]. 

Inflation increases costs arising in the future this can make an alternative which is more expensive initially, but has lower maintenance costs, more attractive. In effect, it reduces the effective interest rate in a DCF calculation. This can be taken into account by using a variation of the above equation. If the annual inflation rate is / %, then... 

This equation should be used with care. Inflation rates can change substantially, and are difficult to predict over a long period when assumptions can cause serious errors. Moreover, the effect of inflation on different items may not be the same for example, labour intensive activities generally have a higher inflation rate than the cost of materials. It may, therefore, be misleading to use a single inflation rate for all the costs in a calculation, whereas a single interest rate is usually valid. 

Step 6 Estimate disruption during maitenance (or erection). As with maintenance costs these can be entered at present costs of such disruption whenever interest rates equal inflation rate. 

Inflation depreciates money in a manner similar to, but different from, the idea of discounting to allow for the time value of money. The effect of inflation on the net cash flow in future years can be allowed for in a similar manner to the net present worth calculation given by equation 6.9, using an inflation rate in place of, or added to, the discount rate r. However, the difficulty is to decide what the inflation rate is likely to be in future years. Also, inflation may well affect the sales price, operating costs and raw material prices differently. One approach is to argue that a decision between alternative projects made without formally considering the effect of inflation on future earnings will still be correct, as inflation is likely to affect the predictions made for both projects in a similar way. 

No information on the cost of a specific polystyrene plant could be found in the literature. One 1969 source18, however, listed the average cost of a polystyrene plant as between 100 and 205 per annual ton. This will be extrapolated to 1974, using the Chemical Engineering Plant Design Index and an assumed inflation rate. 

Inflation can be a significant factor in analysis of profitability. High inflation rates frequently occur in many countries. In computing the rate of return or net present value, you need to obtain a measure of profitability that is independent of the inflation rate. If you inflate projections of future annual income, the computed rate of return may largely result from the effects of inflation. Most companies strive for an internal rate of return (after taxes) of 10-20 percent in the absence of inflation ... 

It is impossible to clearly separate the effects of TSCA from a multitude of other factors which contribute to changes in innovation or the economic condition of the chemical industry. Changes in the tax structure or the inflation rate, for example, have much more impact on innovation and industry R D than does TSCA. But the effects of TSCA cannot be isolated from these other factors. 

The industry-specific inflation rate is different from sector to sector also the inflation rate in the USA is different from that in the EU. In addition, the exchange rate between US dollars and euros has historically fluctuated to a large extent. It is assumed that the different inflation rates in the USA and the EU partly compensate for the error, which would be made if the exchange rate were assumed to be one euro per US dollar. To avoid modifying the figures indicated in the original literature sources, in this book the exchange rate is thus assumed to be one euro per US dollar. 

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