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L12: Actual and Constant Dollars

The document discusses actual and constant dollars in the context of engineering economics. It defines actual dollars as estimates of future cash flows that account for inflation, while constant dollars estimate cash flows independent of inflation in terms of a base period's purchasing power. The document provides examples of converting between actual and constant dollars using inflation rates and conversion factors. It also gives an example comparing the value of winning prizes from different years in terms of constant dollars.

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Sajid Iqbal
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40 views

L12: Actual and Constant Dollars

The document discusses actual and constant dollars in the context of engineering economics. It defines actual dollars as estimates of future cash flows that account for inflation, while constant dollars estimate cash flows independent of inflation in terms of a base period's purchasing power. The document provides examples of converting between actual and constant dollars using inflation rates and conversion factors. It also gives an example comparing the value of winning prizes from different years in terms of constant dollars.

Uploaded by

Sajid Iqbal
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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L12: Actual and

Constant Dollars

ECON 320 Engineering Economics


Mahmut Ali GOKCE
Industrial Systems Engineering
Computer Sciences

www.izmirekonomi.edu.tr
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).

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Conversion
from Constant to Actual Dollars
_ _
An  A' n (1  f )  A' n ( F / P, f , n)
n

n3 $1,260
$1,000 _
f  8%

3
3
Actual
Constant
3 Dollars
Dollars $1,000 (1 + 0.08)
= $1,260

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Example 4.3 Conversion from
Constant to Actual Dollars
Period Net Cash Flow in Conversion Cash Flow in
Constant $ Factor Actual $
0 -$250,000 (1+0.05)0 -$250,000

1 100,000 (1+0.05)1 105,000

2 110,000 (1+0.05)2 121,275

3 120,000 (1+0.05)3 138,915

4 130,000 (1+0.05)4 158,016

5 120,000 (1+0.05)5 153,154

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$120,000 $130,000
$110,000
$100,000 $120,000

0
1 2 3 4 5
Years

$130,000(1+0.05)4

$120,000(1+0.05)5
(a) Constant dollars
$100,000(1+0.05)

$120,000(1+0.05)3
$110,000(1+0.05)2
$250,00
0
$250,000(1+0.05)0

$138,915 $158,016
$121,275
$105,000 $153,154

0
1 2 3 4 5
Years
(b) Actual dollars
$250,000
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Conversion
from Actual to Constant Dollars
_ _
n
A' n  An (1  f )  An ( P / F, f , n)
n3 $1,260
$1,000 _
f  8%

3
3
Actual
Constant -3
$1,260 (1 + 0.08) Dollars
Dollars
= $1,000

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Example 4.4 Conversion from
Actual to Constant Dollars
End of Cash Flow in Conversion Cash Flow in Loss in
period Actual $ at f = 5% Constant $ Purchasing
Power
0 -$20,000 (1+0.05)0 -$20,000 0%

1 20,000 (1+0.05)-1 -19,048 4.76

2 20,000 (1+0.05)-2 -18,141 9.30

3 20,000 (1+0.05)-3 -17,277 13.62

4 20,000 (1+0.05)-4 -16,454 17.73

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Practice Problem - How to Compare the Winning
Prizes in Two Different Points in Time

1963 2004
Jack Nicklaus won his first Master Phil Mickelson won his first
Tournament in 1963. The prize Master Tournament in 2004.
was $20,000. The prize amount was $1.17M.

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Consumer Price Index

91.7 100 561.23

1963 2004

1967

Average inflation rate = 4.525%

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What is the worth of $1.17M in
terms of purchasing power in
1963?

The average inflation rate between


1963 and 2004 is about 4.53% per
year.

$1.17M in 2004 would have a purchasing power of


$190,616 in 1963

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If Jack invested his prize money in 1963 at 5.65%
(inflation-free interest rate), the prize money
would grow to match Phil’s 2004 prize.

$20,000

0
1963
$190,616

P  $190,616( P / F ,5.65%, 41)


 $20,000
41
0
2004
1963

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