Interest Rates, Inflation and Pricing

 5. Inflation
 1.0 INTRODUCTION
 5.1 Price Inflation
 1.1 Definitions
 2.0 CALCULATION OF INTEREST  5.2 Using index to measure Price
level change
 2.1 Simple interest, Effective and
nominal interest rate  5.3 Measures of Inflation
 2.2 Calculation Simple interest,  5.4 Causes of Inflation
Effective and nominal interest  5.5 Measures to control inflation
rate
 5.6 Effects of inflation
 3. 0 INTEREST FORMULAS AND
TABLES IN RELATION TO  5.6.2Advantage of inflation
ENGINEERING ECONOMY  5.6.3Disadvantages of inflation
 3.1 Cash Flow Diagram.  5.7 Inflation and investment
 3.2 Interest Calculation  5.8 Inflation calculation
 4.0 Pricing
 6.0 CONCLUSION

1
 Chapter introducing to engineering economy
studies, deal with mathematical method of
calculating interest rate (simple and compound)
and equivalence as basis for making engineering
economy studies.
 It is important that engineers should be able to
appreciate the value of money and interpret its
use in a way similar to that in which they
interpret all the other materials and resources in
which they endeavor to design economically.
 Interest rate table giving three significant figures
are adequate for purpose of most economy
studies.

2
 Interest may be defined as money paid for the use of
borrowed money.
 The rate of interest is a ratio between the chargeable or
payable at the end of time, usually a year or less, and the
money owed at the beginning of the period.
 When interest is paid on not only the principal amount
invested, but also on any previous interest earned, this is
called compound interest
 Nominal interest rate is annual rate of interest without
considering the effect of any compounding during the
year.
 Effective annual interest rate is annual interest rate taking
into account the effect of any compounding during the
year.
 Inflation is the situation where price of goods and services
are increasing time to time while deflation is the reverse.

3
Interest = Principle X Interest rate X Time
I= P. i. n
Effective annual interest rate Ieff = ( 1 + r/m)m -1
Where r = nominal annual interest rate in decimal
m = number of compound period per year

1) If bank pay 1.5 interest in saving account every three months. What is
Nominal and effective interest rate.
a) Nominal interest rate is = (12/3)*1.5= 6%
b) Effective interest rate Ieff = ( 1 + i /m)m-1
= ( 1 + 6/4)4 -1 = ( 1 + 1.5)4 -1
= 0.06136 =6.136%

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2 )If loan of Tsh 1000, nominal interest of 10% compounded quarterly. What is
effective interest rate?
Solution
Ieff = ( 1 + r/m)m-1 = ( 1 + 0.1/4)4 -1 = 0.1038
The annual interest would be 1000(0.1038) = 103.8

5
 If a bank pays 2% interest in saving account
every 3 months, what is the nominal and
effective interest rate?
 In solving any interest problem, it is necessary to note
which of the various elements of such problems (i, n, P,
F, and A) are known and which are wanted.
 F = future value, a value at some future point in time
 P = present value, a value today which is usually
designated as time 0
 i = rate of interest per compounding period
 n = number of compounding periods
 A = Uniform series
 S= Salvage or resale value

7
 The solution of engineering economics problems that
involve evaluation and or comparison of cash flow is
facilitated by preparing diagrams representing the
movement of cash over time.
 Arrows pointing downward indicate negative cash flow
and upward indicating positive cash flow or cash receipts.

F
P

1 2 3
1 2 3
P
(a) (a) i=10%
i=10%

8
3.2.1 Single Payments
F = P (1+ i)n where (1+ i) n Known as single payment compound amount factor.

Notation (F/P,i%,n) That is F = P (1+ i)n is P(F/P,i%,n)

3.2.2 Uniform series Payment

F = A(F/A, i%, n) compound amount
A= F(A/F, i%, n) Uniform series sinking fund
P = A(P/A, i%, n) Present worth
A = P(F/P, i%, n) Capital recovery

9
3 ) How much will accumulate in individual retirement account in 15 years if 500
is deposited in the account at the end of each quarter during that time? The account
earn 12% interest compounded quarterly. What is effective interest rate?(Test
2006)
Solution
F=?, N= 15 years, A =500, n= 4*15=60, r = 12, i= 12/4= 3%
F = A(F/A, i%, n) compound amount
F = 500(F/A, 3%, 60) = 500(163.053) =81,526.5
b) Effective interest rate Ieff = ( 1 + r/m)m-1 = ( 1 + 0.12/4)4 -1 = 0.1255 =
12.55%.
 (1) How much a family can invest from now to provide a
lump sum of £1000 for school fees at the end of six years
from now if interest rate is 5%.
Solution
I= 0.05, n= 6, F= £1000, P=?
P = F (1+ i)n is P = F(P/F, i%, n) then
P=100(P/F,5%,6)
=1000(0.742) = £742
F (1000)

(a) 6
P i=5%
?

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 (2) If £1000 invested at 6% compound interest on 1981
how much will be accumulated on 1991?
Soln
I= 0.06, n=10 P=£1000, F=?
By table isF= P(F/P,i%,n)
= 1000(1.791)= £1791

(a) i=6% 10
P (1000)

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 (3) If £840 is invested at 6% on 1978, what
equal year end withdrawals can be made
each year for ten years, leaving nothing in
the fund after the tenth withdrawals?
Soln
i= 0.06, n=10, P=£840, A=?
By table is A = P(A/P, i%, n)
= 840(0.13587)
= £114.1

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 (4) How much must be deposited at 6%
interest each year for 7 years beginning on
1982 in order to accumulate £ 1504 on the
date of last deposit, 1988.
Soln
i= 0.06, n=7, F=£1504, A=?
By table is A= F(A/F, i%, n)
= 1504(0.11914)
= £179.2

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 (5) How much would you need to deposit at
6%, on January 1981, in order to draw out
179.2 at the end of each years, for 7 years
leaving nothing in fund at the end?
Soln
i= 0.06, n=7, A=£179.2, P=?
By table is P= A(P/A, i%, n)
= 179.2(5.582)
= £1000

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• A bond is simply a long term debt.
• When you own a bond, you receive a
fixed interest payment each year until
the bond matures.
• This payment is known as the coupon.
 At maturity the debt is repaid.
 The amount that is repaid is known as the
bond’s face value, par value, or maturity
value.
 Suppose you bought the 9% coupon bond in
2008, each bond having the face value of
1000Tsh. and maturing in 2013. You could
then look forward to the following cash
payments.
2008 2009 2010 2011 2012 2013
90 90 90 90 90 1090
 What is the market value of this stream of
cash flows?
 To answer, we need to look at the return
provided by similar securities.
 In 2008 Tanzania Government Treasury
bonds with similar maturities offered a
return of about 7%.
 Therefore, to value these bonds, we need to
discount the prospective stream of cash
flows at 10%

 NPV = F(P/F,7%,6) + A(P/A,7%,6) = 1000 +

1000 X 0.663 + 90 X 4.767
= Tshs 1092
 Suppose you are considering purchase of a
bond.
 Your investment adviser quotes a current
price.
 How do you calculate the rate of return the
bond offers.
 For bonds purchased at face value the
answer is easy.
 The rate of return is the coupon rate
 A measure of rate of return that takes
account of both current yield and
appreciation or depreciation of a bond’s
value over its life is called yield to maturity
or internal rate of return.
 This is the discount rate that makes the
present value of bonds payments equal to its
price.
Example No.1
 If the price of the bond is 1158.87, what
return do investors expect? Face value is
1000 and coupon rate is 9%.
 PV = {90/(1+r) } + {90/(1+r)2} + {90/(1+r)3}
+ {90/(1+r)4} + {1090/(1+r)5}
 PV = 1158.87 through trial and error

 r = 5.3% (This is the Yield to Maturity)

 Inflation is the situation where price of goods
and services are increasing time to time while
deflation is the reverse.
 Causes of inflation are (1) Demand pull
inflation (2) Cost push Inflation.
 Demand-pull Inflation caused by excessive
demand, demand is greater than supply
causing price increases.
 Cost –push Inflation are the inflation which
occur when firm’s costs go up, to maintain
their profit margin they put their price up.

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 The number of goods that
are representative of
economy are put together
into Market basket.
 Cost of this basket result CPI this year-CPI previous year
the price index, ie Inflation rate = X100
Customer Price index (CPI) CPI previous year
and Producer Price index
(PPI).
 CPI Measure the cost of
living
 PPI measure the price PPI this year-PPI previous year
change form the seller Inflation rate = X100
PPI previous year

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 A consumer price index (CPI) measures
changes in the price level of consumer goods
and services purchased by households.
 The CPI in most countries is defined by the
Bureau of Labor Statistics as "a measure of
the average change over time in the prices
paid by urban consumers for a market basket
of consumer goods and services.
 The CPI is a statistical estimate constructed
using the prices of a sample of representative
items whose prices are collected periodically.
 Sub-indexes and sub-sub-indexes are
computed for different categories and sub-
categories of goods and services, being
combined to produce the overall index with
weights reflecting their shares in the total of
the consumer expenditures covered by the
index.
 It is one of several price indices calculated by
most national statistical agencies.
 The annual percentage change in a CPI is
used as a measure of inflation.
 Two basic types of data are needed to
construct the CPI: price data and weighting
data.
 The price data are collected for a sample of
goods and services from a sample of sales
outlets in a sample of locations for a sample
of times.
 The weighting data are estimates of the
shares of the different types of expenditure in
the total expenditure covered by the index.
 These weights are usually based upon
expenditure data obtained from expenditure
surveys for a sample of households
 Calculating the CPI for a single item?
 Calculating the CPI for multiple items?
 Demand-pull inflation
(I) Increase income tax to reduce consumer
spending
(ii)Control supply of money
(iii)Reducing government spending.
(iv) Reduce salaries and wages
 Cost-push inflation
 Reduce indirect taxation.
 Cost controls
 Enhance competition among providers

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 Advantage of inflation
1)Firm increasing prices and profit before they
pay out higher wage
2)Debtor(borrowers) gain they use money now
so get interest free loan
 Disadvantages of inflation
1)Creditor lose when loan paid
2)Fixed income people suffer
3)Domestic products become less competitive
to foreign products

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Table 1: Tanzania Consumer Price Index And Inflation Rates 1995-2005

Period/year CPI inflation rate

1995 115.8 28.4

1996 140.1 21.0
1997 162.6 16.1
1998 183.5 12.8
1999 197.9 7.9
2000 209.7 5.9
2001 220.4 1
2002 230.5 4.6
2003 240.7 4.4
2004 250.8 4.2

2005 261.8 4.4

Source BOT

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 Inflation reducing the rate of return of
investor to even negative
 When price levels rise (Inflation), the
purchasing power of money goes down.
 This implies that prospective inflation can
be an additional source of lack of
commensurability of cash flows at different
date.

34
 The consumer price index (CPI) is the
government's key inflation indicator.
 The Bureau of Statistics calculates the CPI
each month.
 This index is based on data related to
consumer spending habits and the prices
paid for a variety of goods, including food,
clothing, medications, energy, homes and
furnishings.
 You don't have to be an economist to
calculate the inflation rate on goods you
regularly buy
1. Determine the goods and the time frame
for which you are interested in measuring
the inflation rate. People often want to
know how prices have increased over a
year. Suppose, for simplicity's sake, that
you are interested in the inflation rate for
a basket of goods that includes a litre of
milk, a loaf of bread and sugar
2. Calculate the number of units you
purchase of these goods and the prices
you paid one year ago. For example,
suppose you buy four litres of milk,
three loaves of bread and 6 kg of sugar
per month and that one year ago, you paid
the following prices: Tshs 1000 per litre;
Tshs 750 per loaf; and Tshs 1,500 per kg
of sugar. This means you spent a total of
Tshs15,250 a month one year ago for
these goods.
3. Repeat Step 2, but consider the prices you
pay now. Suppose the current prices are
Tshs 2,000 for a litre of milk and Tshs
1,000 for a loaf of bread, while the price
of a sugar is Tshs 2,400. This means you
now spend Tshs 25,400 a month for the
same basket of items.
4. Subtract the amount you spent per month
one year ago (15,250) from the amount
you spend now (25,400), then take the
difference (10,150) and divide by last
year's amount (15,250). This gives you a
result of 0.665 or 66.5% (with rounding).
5. For this example, the results show that the
consumer price index for 4 milk, a loaf of
bread and a sugar increased 66.5 percent
in the past year
 If an index represent the price of cement
increase $231 to $287 over period of 3 years.
What is inflation rate?
Solution:
F=P(1+f)n
287=231(1+f)3
1+f=(1.2424)1/3
1.075=1+f
f=0.075= 7.5%

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 A project has been analyzed assuming 6%
inflation and found to have monetary
internal rate of return of (IRR) of 22% What
is the real IRR of project.
Solution:
Real IRR
 1+ i  
=
 1+ f  
 1
 
=((1+.22)/(1+.06))-1 =0.1509 =15.09%

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 Mr Maeda borrowed Tsh 700,000 from Joshua in Jan
2011. He was required to pay after one year with interest
of 10% annually. Jushua did not consider inflation then.
But in Jan 2012 when Maeda paid the inflation was 16 %
refer to BOT.
 Soln
Nominal interest rate 10%
Inflation rate=16%
Real interest rate= 10-16%=-6%%
Income Joshua he wished to receive
=700,000+10%x700,000=770,000
But due to inflation Actual money Maeda pay to Joshua
was=700,000-6% *700,000= 658,000.

43
 It is important that engineers should be able to
appreciate the value of money and interpret its use in a
way similar to that in which they interpret all the other
materials and resources in which they endeavor to
design economically.
 The impact of inflation on economy study is that it
reduces the rate of return of investments in various
ways and also it affects individual taxpayers.
 Before signing contracts get first inflation, interest rate
figures and payment schedules.

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 Select 15 market basket of consumer goods
and services
 Establish the prices of the selected goods and
services at two different time periods(use
year as a unit of measure)
 Compute inflation rate
 Submit a brief report