Chapter (7): Inflation Adjusted Decisions

Inflation Adjusted Decisions

Introduction:
A general inflationary trend in the cost of
goods is common everywhere due to various
interacting factors. If the rate of inflation is
very high, it will produce extremely serious
consequences for both individuals and
institutions.
Inflation is the rate of increase in the prices of
goods per period. So, it has a compounding
effect. Thus, prices that are inflated at a rate of
7% per year will increase 7% in the first year, and
for the next year the expected increase will be
7% of these new prices. The same is true for
succeeding years and hence the rate of inflation
is compounded in the same manner that an
interest rate is compounded.
If the average inflation over six years period is 7%,
then the prices at the beginning of the seventh
year would be 150% that of the first year by
assuming 100% for the prices at the beginning of
the first year of the six-year period.
If economic decisions are taken without
considering the effect of inflation into account,
most of them would become meaningless and as a
result the organizations would end up with
unpredictable return.
But there is always difficulty in determining the rate
of inflation. The worldwide trend/wish is to curtail
inflation. But due to various reasons, it is very
difficult to have zero inflation. For practical decision
making, an average estimate may be assumed
depending on the period of the proposals under
consideration. Hence, we need a procedure which
will combine the effects of inflation rate and
interest rate to take realistic economic decision.
Procedure to Adjust inflation:
A procedure to deal with this situation is summarized
now.
1. Estimate all the costs/returns associated with an
investment proposal in terms of today’s rupees.
2. Modify the costs/returns estimated in step 1 using
an assumed inflation rate so that at each future date
they represent the costs/returns at that date in terms
of the rupees that must be expended/received at that
time, respectively.
3. As per our requirement, calculate either the annual
equivalent amount or future amount or present
amount of the cash flow resulting from step 2 by
considering the time value of money.
Example.1:
Suppose a 40-year old man is planning for his
retirement. He plans to retire at the age of 60 and
estimates that he can live comfortably on Rs. 24,000
per year in terms of today’s rupee value
He can invest his savings at 15% compounded
annually. Assume an average inflation rate of 9%
for the next 30 years. What equal amount
should he save each year until he retires so that
he can make withdrawals at the end of each year
commencing from the end of the 21st year from
now that will allow him to live as comfortably as
he desires for 10 years beyond his retirement?
Solution:
Step 1. The estimated future requirement per
year in terms of today’s rupees from his age 61
through 70 is Rs. 24,000.
Step 2. Modification of the costs estimated in
step 1 is summarized in Table .1. The formula
which is given below is used to get future
equivalent of Rs. 24,000 with the inflation of 9%
per year (IR-inflation rate).
 Table .1 Inflated Future Requirements
End of year Age (years) Inflated value of Rs. 24,000 at each year end

21 61 24,000 x = Rs. 1,46,611

22 62 24,000 x = Rs. 1,59,806

23 63 24,000 x = Rs. 1,74,189

24 64 24,000 x = Rs. 1,89,866

25 65 24,000 x = Rs. 2,06,954

26 66 24,000 x = Rs. 2,25,580

27 67 24,000 x = Rs. 2,45,882

28 68 24,000 x = Rs. 2,68,011

29 68 24,000 x = Rs. 2,92,132

30 70 24,000 x = Rs. 3,18,424

Step 3. Now, the calculation of the
equivalent amount of cash flow as per the
requirement is presented.
The overall cash flow diagram for the
savings and withdrawal in terms of future
rupees is shown in Fig.1.
 Fig. 1 Overall cash flow diagram.

3,18,424
2,92,132
1,59,806
1,46,611
0 1 2 3

A A A 21 22 29 30

A A
The sum of the present equivalents of the
year end withdrawals from the year 21 to
30 is computed by assuming the end of the
year 20 as the base (time zero) and it is
shown at the end of the year 20 in Fig. 2.
The method of computing the present
equivalent of the withdrawals is as follows:
 Fig.2 Equivalent cash flow diagram.

10,13,631(F)
19

0 1 2 3
20
A A A

A A
The annual equivalent amount (A), which
should be invested from the end of year 1
(age 41) to year 20 (age 60), is computed
using the following formula.
A= F(A/F, 15%, 20)
= 10,13,631 (0.0098)
= Rs. 9,934
Recommendation: The person has to invest
an amount of Rs. 9,934 at the end of every
year starting from his age 41 (year 1)
through 60 (year 20) which will enable him
to make withdrawals at the end of every
year starting from his age 61 (year 21)
through 70 (year 30) as shown in the Table .1
(also in Fig.1).
Inflation Adjusted Economic Life Of Machine:
In any industrial/service organization,
equipment/machinery forms an important element.
The productivity of any organization is a function of
many factors. It is largely affected by efficient and
effective use of machinery and equipment.
So, operations and maintenance of these equipment
are very important to the organization.
A machine which is purchased today
cannot be used forever. It has a definite
economic lifetime. After the economic
life, the machine should be replaced with
a substitute machine with similar
operational capabilities. This kind of
analysis is called replacement analysis.
The elements of costs involved in the
replacement analysis are as follows:
1. Purchase cost (initial cost).
2. Annual operation and maintenance cost.
3. Salvage value at the end of every year, if
it is significant.
The trade-off between different cost
elements is shown in Fig.3.
 Fig.3 Chart showing economic life.

Total cost

Capital recovery
costs

Cost with return

Average operating &

maintenance cost

Economic Life

Life of the machine

From Fig.3, it is clear that the sum of operation
and maintenance cost increases with the life of
the machine. But the capital recovery with
return decreases with the life of the machine.
The total cost of the machine goes on decreasing
initially but it starts increasing after some years.
The year with the minimum total cost is called as
the economic life of the machine.
Limitation of Existing Model:
In the case where the machine is replaced due to wear and
tear, the following costs are considered:
1. Initial cost.
2. Operation and maintenance cost.
3. Salvage value.
In the existing model to deal with this type of replacement
analysis, the different cost elements are estimated without
taking the effect of inflation into account.
The annual cost of operation and maintenance of
the machine will increase with the age of the
machine due to decline in efficiency of the machine.
In the existing model, this increase in the operation
and maintenance cost is taken into account. But the
increase in the operation and maintenance cost due
to inflation is not considered. Similarly, in the
existing model, the salvage value is estimated
without taking into account the effect of inflation.
To highlight this particular fact on salvage value, an
example is now given.
The internal combustion engines (R.A. Lister) which
were made in England during pre-independence of India
are still functioning well. Their resale value is going up
year after year. This may be partly due to inflation and
partly due to good quality of the engine parts.
So, consideration of the effect of the inflation on the
economic life of the machine is a realistic approach.
In replacement analysis, a discount rate is
usually assumed to reflect the time value of
money. First the concept of replacement
analysis is demonstrated without taking the
inflation into account. Then, the same is
demonstrated by taking the effect of inflation
into account. At the end, a comparison
between the two models is presented.
Example .3 A company has received quotes for
its recent advertisement for the purchase of a
sophisticated milling machine. The data are as
per the estimate in today’s rupee value.
Machine X Machine Y

Purchase price (Rs.) 15,00,000 20,00,000

Machine life (years) 7 7

Salvage value at the end of machine life (Rs.) 2,00,000 3,00,000

Annual operating & maintenance cost (Rs.) 3,00,000 2,50,000

Assuming an average annual inflation of 5%
for the next five years, determine the best
machine based on the present worth method.
Interest rate is 15%, compounded annually.
Solution:
Average annual inflation rate = 5%
Interest rate = 15% compounded annually
Machine X:
Purchase price = Rs.15,00,000
Machine life = 7 years
Salvage value at the end of machine life = Rs. 2,00,000
Annual operating & maintenance cost = Rs. 3,00,000
The computation of the present worth of the annual
operating and maintenance costs of the machine X is
summarized in Table .3.
 Table .3 Computation of the Present Worth of the
Annual Operating and Maintenance Costs of Machine X
End of Annual operating& Inflation Inflated annual P/F, Present worth of inflated
Year(n) maintenance Cost (Rs.) factor(F/P,5%,n) operating 15%,n annual operating &
&maintenance maintenance cost
cost (Rs.)
A B C D E F (Rs.)

B× C D×E

1 3,00,000 1.050 3,15,000 0.8696 2,73,924

2 3,00,000 1.102 3,30,600 0.7561 2,49,967

3 3,00,000 1.158 3,47,400 0.6575 2,28,416

4 3,00,000 1.216 3,64,800 0.5718 2,08,593

5 3,00,000 1.276 3,82,800 0.4972 1,90,328

6 3,00,000 1.340 4,02,000 0.4323 1,73,785

7 3,00,000 1.407 4,22,100 0.3759 1,58,667

Rs. 14,83,680
The equation for the present worth of the machine X is
PWX(15%) = Purchase price + Present worth of inflated
annual and operating cost – Present worth of the
salvage value = 15,00,000 + 14,83,680 – 2,00,000
×(inflation factor) × (P/F, 15%, 7)
= 15,00,000 + 14,83,680 – 2,00,000(F/P, 5%, 7) (P/F,
15%, 7)
= 15,00,000 + 14,83,680 – 2,00,000 × 1.407 × 0.3759
= Rs. 28,77,901.74
Machine Y:
Purchase price = Rs. 20,00,000
Machine life = 7 years
Salvage value at the end of machine life = Rs.
3,00,000
Annual operating & maintenance cost = Rs. 2,50,000
The computation of the present worth of the annual
operating and maintenance costs of the machine Y is
summarized in Table .4.
 Table .4 Computation of the Present Worth of the
Annual Operating and Maintenance Costs of Machine Y.
End of Annual operating& Inflation Inflated annual P/F, Present worth of inflated
Year(n) maintenance Cost (Rs.) factor(F/P,5 operating &maintenance 15%,n annual operating &
%,n) cost (Rs.) maintenance cost
A B C D E F (Rs.)
B× C D×E
1 2,50,000 1.050 2,62,500 0.869 2,28,270
6
2 2,50,000 1.102 2,75,500 0.756 2,08,306
1
3 2,50,000 1.158 2,89,500 0.657 1,90,346
5
4 2,50,000 1.216 3,04,000 0.571 1,73,827
8
5 2,50,000 1.276 3,19,000 0.497 1,58,607
2
6 2,50,000 1.340 3,35,000 0.432 1,44,821
3
7 2,50,000 1.407 3,51,750 0.375 1,32,223
9
Rs. 12,36,400
The expression for the present worth of machine Y is
PWY(15%) = Purchase price + present worth of
inflated annual and operating cost – present worth of
the salvage value = 20,00,000 + 12,36,400 – 3,00,000
× (inflation factor) × (P/F, 15%, 7) = 20,00,000 +
12,36,400 – 3,00,000 (F/P, 5%, 7) (P/F, 15%, 7) =
20,00,000 + 12,36,400 – 3,00,000 × 1.407 × 0.3759
= Rs. 30,77,732.61
Remark. Since the present worth cost of machine X is
less than that of machine Y, select machine X.
Example.4 :
A company is planning to start an employee
welfare fund. It needs Rs. 50,00,000 during the
first year and it increases by Rs. 5,00,000 every
year thereafter up to the end of the 5th year. The
above figures are in terms of to days rupee value.
The annual average rate of inflation is 6% for the
next five years. The interest rate is 18%,
compounded annually.
Find the single deposit which will provide the required
series of fund towards employees welfare scheme
after taking the inflation rate into account.
Solution:
Fund requirement during the first year = Rs. 50,00,000
Annual increase in the fund requirement = Rs.
5,00,000 Annual inflation rate = 6%
Interest rate = 18%, compounded annually
The computation of the present worth of the annual
fund requirements is summarized in Table .5.
Table .5Computation of the Present Worth of the Annual
Requirements:
End of Annual fund Inflation Inflated annual fund P/F, Present worth of inflated annual
Year(n) requirements (Rs.) factor(F/P,6%,n) requirements (Rs.) 18%,n fund requirements

A B C D E F (Rs.)
B× C D×E
1 50,00,000 1.060 53,00,000 0.8475 44,91,750

2 55,00,000 1.124 61,82,000 0.7182 44,39,912

3 60,00,000 1.191 71,46,000 0.6086 43,49,056

4 65,00,000 1.262 82,03,000 0.5158 42,31,107

5 70,00,000 1.338 93,66,000 0.4371 40,93,879

Rs. 2,16,05,704

The value of the single deposit to be made now to receive the

specified series for the next five years is Rs. 2,16,05,704.
 Questions
1. Define inflation.
2. Discuss the impact of inflation on investment
decision.
3. Suppose a 50-year old man is planning for his
retirement. He plans to retire at the age of 60 and
estimates that he can live comfortably on Rs. 40,000
per year in terms of today’s rupee value.
Let us assume the average inflation rate for the
next 20 years is 7% per year. This is only an
assumption. He can invest his savings at 20%,
compounded annually.
What equal amount should he save each year
until he retires so that he can make withdrawals
that will allow him to live as comfortably as he
desires for 10 years beyond his retirement?
Thank You