L12: Actual and Constant Dollars

1. L12: Actual and Constant Dollars ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

2. 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).

3. 3 $1,000 (1 + 0.08) = $1,260 Conversion from Constant to Actual Dollars $1,260 $1,000 3 3 Actual Dollars Constant Dollars

4. Example 4.3 Conversion from Constant to Actual Dollars

5. $130,000 $120,000 $110,000 $120,000 $100,000 0 1 2 3 4 5 Years (a) Constant dollars $250,000 $130,000(1+0.05)4 $120,000(1+0.05)5 $100,000(1+0.05) $120,000(1+0.05)3 $110,000(1+0.05)2 $250,000(1+0.05)0 $158,016 $138,915 $121,275 $153,154 $105,000 0 1 2 3 4 5 Years (b) Actual dollars $250,000

6. -3 $1,260 (1 + 0.08) = $1,000 Conversion from Actual to Constant Dollars $1,260 $1,000 3 3 Actual Dollars Constant Dollars

7. Example 4.4 Conversion from Actual to Constant Dollars

8. Practice Problem - How to Compare the Winning Prizes in Two Different Points in Time 1963 2004 Jack Nicklaus won his first Master Tournament in 1963. The prize was $20,000. Phil Mickelson won his first Master Tournament in 2004. The prize amount was $1.17M.

9. Consumer Price Index 561.23 91.7 100 2004 1963 1967 Average inflation rate = 4.525%

10. 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

11. 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 41 0 2004 1963