12. Inflation

Question 1

What does the governor of Canada say about interest rates?

Answer 1

He can keep them “under control”

- Rene doesn’t believe

Question 2

Why did interest rates rise following covid?

Answer 2

Container crisis (they are in the wrong places)
People are starting to spend
Energy crisis

Question 3

How do banks combat inflation?

Answer 3

• Banks will rase interest rates, which will calm spending, which reduces inflation
• However raising interest rates has negative effect on housing and economy

Question 4

What is the CPI?

Answer 4

CPI is a statistical measure of the change of the prices of G&S over time
The CPI measures the cost of a sample “market basket” of G&S in a specific period with the cost of the same “market basket” in an earlier reference period.

Question 5

How do you use CPI to calculate the general (average) inflation rate? Use the picture to help you.

Answer 5

Take the future CPI to be future worth and current CPI to be present worth.

Question 6

Whats the difference between constant dollars and actual dollars?

Answer 6

Constant (real) dollars: estimate future cash flows for year n in constant purchasing power (no inflation) - use MARR (An’)
Actual (current) dollars: estimates of future cash flows for year n that take into account changes caused by inflation/deflation (An)

Question 7

Describe what’s happening in this picture.

Answer 7

Converting between constant and actual dollars. Here we use f with hat which is inflation rate.

Question 8

What’s the difference between real and nominal discount rates?

Answer 8

Real discount rate (i’) is MARR (inflation-free)
Nominal discount rate (i) is inflation adjusted MARR. It takes into account the earning power and the possible inflation.

*real dollars (inflation-free) also have little ‘

Question 9

How do we take into prepare cash flows in current dollars (ie with inflation) ?

Answer 9

We need to factor in inflation for:
- income
- labor
- materials
- expenses
Loan payments and depreciation stay in real dollars (not affected by inflation)

Question 10

Does inflation affect depreciation and loan payments?

Answer 10

No

Question 11

How do you calculate the nominal discount rate?

Answer 11

We must adjust real discount rate (i’) to account for inflation.

i = nominal rate (with inflation)
i' = real rate (inflation-free)
f = inflation rate

Question 12

How do you deflate cash flows?

Answer 12

Option 1: Convert current dollars to real dollars and then deflate at real discount rate
Step 1: Eliminate the effect of inflation by dividing them by (1+f)^n
Step 2: Discount them using the real discount rate i’

Option 2: Discount current dollars using nominal interest rate

Question 13

How does inflation effect borrowed funds?

Answer 13

Payment size does not change with inflation.
Borrowers repay the historical loan amount with dollars of decreasing purchasing power (value).
Good for consumer, bad for bank

Question 14

What is the effect of inflation on return on investment?

Answer 14

• Lowers NPW and increases IRR
  (Unless revenues are sufficiently increased to keep up with inflation and tax effects)
• Real IRR, inflation-free rate of return (IRR’) is calculated using constant dollars (A’)
• Current (actual) IRR is calculated using current dollars (A)
• IRR = IRR’ + f + IRR’f

Question 15

What is the effect of inflation on depreciation?

Answer 15

Depreciation is always given in actual dollars (with inflation)
- Automatically takes inflation into account

Question 16

What’s the effect of inflation on working capital?

Answer 16

• Working capital is cash, accounts receivable and inventory. It is available to meet day-to-day operating needs
• Inflation generates “working capital drain” because with inflation companies need more working capital to operate (ex: maintain inventory level)

Question 17

How does inflation affect elements in a cash flow diagram?

Answer 17

Increases revenue (+)
Increases taxes (+)
Increases material and labour costs (-)
*Depreciation and loan stay the same

Question 18

Who suffers more from inflation, consumers or companies?

Answer 18

Both! sucks fo everyone :(

Question 19

What goes into taxable income?

Answer 19

Revenue (+) + Costs (-) + Expenses (-) + Loan payment (-)

*costs include labour, material and depreciation

Question 20

How will this cash flow diagram change if you take inflation into account?

Answer 20

Increase costs (-), increase expenses (-), increase revenues (+)
(increase by multiplying by inflation rate: 2%)
Use nominal discount rate 14.24% in PV formula.

*Depreciation and amortization don’t change

Question 21

The net cash flow in current dollars is calculated and then converted into real/constant dollars using the formula A’ = A/(1+f)^n. Why are the NPVs for both cash flows the same?

Answer 21

For current/actual dollars, the nominal discount rate (i) is used to calculate NPV
For real/constant dollars, the real discount rate (i’) is used to calculate NPV.

Question 22

Is salvage value affected by inflation?

Answer 22

Yes. It increases according to the formula F=P(1+i)^n